Inheriting Real Estate? Why You Need to Know the Property’s Basis

whoffman3

10 minutes ago

4 min read

Inheriting a house, farm, rental property, or other real estate can come with significant tax consequences down the road. One of the most important—and often overlooked—issues is the property’s tax basis. If you inherit real estate, the basis of that property is generally adjusted to its fair market value as of the date of the owner’s death. This is commonly referred to as a “step-up in basis.” That adjustment can make a substantial difference if you eventually sell the property.

What Is Tax Basis?

Your tax basis is essentially the starting point for determining whether you have a taxable gain when you sell property. For example, suppose your parents purchased a house 30 years ago for $150,000. Over the years, the property appreciates significantly and is worth $600,000 when they pass away.

If you inherit the property, your basis generally is not simply the $150,000 your parents originally paid for it. Instead, your basis is generally adjusted to the property's fair market value as of the date of death.

If the property is worth $600,000 on the date of death, your new basis would generally be approximately $600,000. If you later sell the property for $625,000, you would generally have a much smaller taxable gain than you would have had if your basis remained at $150,000. That is why determining and documenting the date-of-death value is so important.

Why Does an Appraisal Matter?

The IRS does not simply take your word for what a property was worth when someone died.

If the property is eventually sold, you may need to establish what the property's basis was. That means you need reasonable documentation supporting the property's fair market value as of the date of death.

A date-of-death appraisal is one of the best ways to create that documentation. A qualified appraiser can prepare an appraisal establishing the property's fair market value as of the date the owner died—even if the appraisal is actually performed months later. This can be particularly important with:

Family homes that have appreciated substantially;
Farms and large tracts of land;
Investment or rental properties;
Commercial real estate;
Vacation homes; and
Unique or difficult-to-value properties.

The appraisal gives the estate and the beneficiaries a record of the property's value that can be preserved for future use.

What If You Don't Get an Appraisal?

Not having an appraisal does not necessarily mean you lose the step-up in basis. The bigger problem is documentation. Imagine that your mother purchased a beach house decades ago for $100,000. She passes away when the property is worth $750,000. You inherit it and hold it for another five years before selling it for $800,000.

If your basis is properly established at approximately $750,000, your gain may be relatively small. But five years later, how do you prove what the property was worth on the date your mother died?

The property may have changed. The real estate market may have changed. Comparable sales from that period may no longer be readily available. And the people who handled the estate may not remember exactly how the value was determined. A professional appraisal obtained around the time of death can eliminate much of that uncertainty.

The Estate Tax Return Is Not the Only Consideration

Another common misconception is that a formal estate tax return must be filed before you can establish the property's basis. That is not necessarily the case.

Most estates do not owe federal estate tax, and many estates do not require the filing of a federal estate tax return. But that does not mean the estate can ignore basis.

The estate and its beneficiaries should still maintain records supporting the value assigned to inherited property.

In some circumstances, an estate tax return may be filed even though no estate tax is ultimately due—for example, to make certain elections or preserve a deceased spouse's unused exemption. In those situations, the valuation of real estate can become even more important. The specific circumstances of the estate should be reviewed with the estate's attorney and tax professional.

What Should You Keep?

When someone dies owning real estate, I generally recommend creating a file containing documentation of the property's value and ownership. That may include:

A date-of-death appraisal;
The property's most recent tax assessment;
Recent purchase or sales information;
Comparable sales used to determine the property's value;
Property photographs, when appropriate;
Closing statements from the eventual sale;
Records of significant improvements made after the date of death; and
Estate and tax records relating to the property.

Keep these records even after the estate has been closed. The property may not be sold for years, and the person ultimately responsible for selling it may not be the person who handled the estate.

Don't Wait Until You Sell the Property

One of the biggest mistakes I see with inherited real estate is waiting until the property is being sold to start thinking about basis. By then, it may be much more difficult to reconstruct the property's value as of the date of death. If you recently inherited real estate, or if you are handling an estate that includes real estate, determining and documenting the property's date-of-death value should be part of the process—not an afterthought.

A relatively small expense for an appraisal and proper recordkeeping today can potentially save significant time, expense, and tax headaches years later. If you are administering an estate or have recently inherited real estate, talk with your attorney and tax advisor about establishing and documenting the property's basis before moving forward.