How a Step-Up in Basis Can Be Good at Tax Time

Craftsman style house

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A step-up in basis can be a very good thing at tax time. The term relates to capital gains tax and can save you considerable money should you ever decide to sell an asset or property that you've inherited. 

Step-Up in Basis

Capital gains tax begins with your basis in an asset—what you paid for it and, in some cases, the cost of any capital improvements you've made. You'll pay capital gains tax on the difference between the sales price and your basis when you sell the property, or you may have a capital loss if the sales price is less than your basis.

Your basis in inherited property is not what the decedent initially paid for the asset. It's "stepped up" to the asset's value as of his date of death, and this can make a big difference. This step-up in basis applies to all inherited assets, including stocks, bonds, and real estate. 

How the Step-Up in Basis Saves You Tax Dollars

Here's an example for illustrative purposes. You've inherited a house from your father. He paid $50,000 for the house 30 years ago. You don't want to live in the house or go through the hassle of renting it out, so you put it up for sale.

It sells for $400,000. Under normal tax rules, you would owe capital gains tax on $350,000 in profit without a step-up in basis. You could pay a capital gains tax rate of as much as 20 percent or more on that profit, depending on how much other income you have and how long you kept the house before you sold it. 

Now let's look at the same scenario using a step-up in basis. Even though your father paid only $50,000 for the house, it was valued at $350,000 as of his date of death. This is your stepped-up basis: $350,000, not $50,000, a significant difference. You would only owe capital gains tax on $50,000 in profits. 

A Note About Capital Gains Tax Rules

Capital gains are either short-term or long-term. If you sell the house within a year of taking ownership, this is a short-term gain and it's taxable as ordinary income. You could pay as much as 28 percent in this case if you earn $100,000 a year and you're single—this is the income tax bracket you'd fall into. But if you earn $36,000, you'd be in a 15-percent tax bracket (as of 2018), so this is all you'd pay.

Then there's the "home sales tax exclusion" rule that might save you from paying capital gains on this type of asset entirely. If you inherit real estate and live in it for at least two years before selling it and are single, you can realize up to $250,000 in capital gains without paying taxes on it if you're single. If you're married and file jointly, you can realize up to $500,000 in gains without being taxed.

You must use it as your principal residence. Coupled with the step-up in basis on your father's property bringing your gain down to $50,000, you would owe no capital gains tax at all as long as you actually live in the property for at least two years.