Basics of Tax Basis for Homeowners and Their Heirs
As a realtor, I don’t give tax, legal, or financial advice, but keep in mind that people do reach out to me when they are ready to buy or sell real estate. So, the goal of this article is to provide a high-level overview of how tax (capital gains) can be impacted when transferring real estate from the current homeowner to their heirs. Everyone’s situation and goals are different so hopefully this article can serve as a prompt on why you should consider professional legal / financial advice based on your specific needs.
What Is Real Estate Basis?
Initially, the idea of a capital gain can be a little unclear. In simple terms, a capital gain is the profit made on an investment. Keep in mind, a capital gain is NOT the gross amount of the sale, but it is the difference between what you sell for and how much you have invested.
The formula for determining a capital gain is straightforward:
Capital Gains (or Losses) = Sale Price - Basis - Selling Expenses
Ex: Sale Price: $700,000 – Basis: $300,000 – Selling Expense: $20,000
= Capital Gain of $380,000
“Basis” is how much you have invested. In very general terms, the basis of a property is what you purchased the property for plus fees & improvements. Once the basis is established, it is used to calculate capital gains or losses when you sell the property.
What we will outline is the basis for an heir can be impacted based on how and when they become listed as an owner of the property.
The higher your basis, the lower your potentially taxable gain when you sell.
Determining Basis for Purchased Property
For property that you purchase, the starting basis is generally the price you paid, plus certain costs like closing fees, legal expenses, and major capital improvements (e.g., adding a new roof or renovating a kitchen).
Basis for Inherited Property
If you inherit property, the rules are likely going to be more favorable for tax purposes. The basis of the inherited property is typically “stepped up” to the property’s fair market value (FMV) as of the date of the original owner’s death.
For example:
• If your parents bought a home for $100,000 and it’s worth $500,000 when you inherit it, your basis is $500,000.
• If you sell the property for $500,000, you’ll owe no capital gains tax.
This stepped-up basis minimizes the tax burden for heirs, making inherited property more advantageous from a tax perspective compared to gifted property.
Basis for Gifted Property
When you receive property as a gift (while the owner is still alive), the basis is different. It’s generally the same as the donor’s original basis, often called “carryover basis.”
For example:
• If your grandparents bought a home for $100,000 and gift it to you while they are still alive, your basis is $100,000, even if the property is now worth $500,000.
• If you later sell the home for $500,000, the capital gain would be $400,000 (sale price minus basis).
Additionally, if the donor’s original basis is lower than the FMV and you sell the property for less than its FMV but more than the original basis, special rules may apply.
Key Differences Between Inherited and Gifted Property
1. Inherited Property: Gets a step-up in basis (favorable from a tax perspective) to the FMV at the time of death. This typically reduces or eliminates capital gains taxes when you sell.
2. Gifted Property: Keeps the donor’s original basis, potentially resulting in higher capital gains taxes when sold.
Why Does This Matter for You?
Understanding these rules is essential for anyone dealing with property transfers. As a realtor, I often recommend consulting a tax or legal professional when planning your estate. The right strategy can make the property transfer as smooth as possible and potentially save your heirs thousands in taxes when they decide to sell.
Have questions about buying, selling, or managing real estate? I’m here to help. While I don’t provide legal, tax, or financial advice, I’m am happy to provide you a few recommendations of estate planning professionals to help guide the discussion.
