Spouses owning real estate can consider strategies to maximize step-up in basis

When an individual passes away, their assets are considered to fall in one of two categories. Items such as retirement accounts and final paychecks are considered “income in respect of a decedent” (IRD) and are subject to income tax. However, other items such as real estate are subject to a step-up in basis.

So, what is a step-up in basis and how it is calculated? Before you can understand that you need to understand a couple of other terms, namely the cost basis for real estate and capital gains tax. The cost basis is basically the value of your property for taxation purposes. It is the cost basis that is used to determine the amount of capital gains taxes you will pay on a property when you sell it. That is because when a person sells a piece of real estate, the profit or loss is calculated by subtracting the property’s cost basis from the sale’s price. The cost basis, absent any exceptions (such as that step-up in basis we will talk about shortly) is the original value the buyer paid for the property. So, if you bought a home in 2010 for $300,000 and sold it in 2022 for $400,000, $300,000 is your cost basis, which is subtracted from the sale price to show a profit of $100,000. That $100,000 would be subject to capital gains taxes.

Capital gains tax is paid on any appreciable asset when it’s sold for more money compared to when you bought it. While most things depreciate in value over time, some items like stocks and real estate tend to appreciate. For those appreciable assets, the length of time one owns an asset impacts capital gains taxes in two ways. First, there is a higher capital gains rate for those assets sold when holding them for less than a year. These sales are taxed at the short-term capital gains rate which is your ordinary income tax level. The sale of items held for longer than a year are taxed at a lower long-term rate. Second, and most applicable to the step-up in basis, is the fact that the longer you own a property the likelihood of a greater appreciation and thus a larger amount of capital gains tax you will be required to pay.

That finally brings us to the step-up in basis. A step-up in basis takes an asset’s cost basis and resets it to the fair market value at the time the beneficiary inherits a property. The logical question is, why is this important? Because a step-up in basis can result in significant tax savings for a beneficiary of a property if they later decide to sell it. Let’s illustrate this by taking the above example and adding in a couple more facts. The individual that purchased this home in 2010 for $300,000 passed away in 2021. His will bequeathed this property to his sister. At the time this individual passed away his property appreciated in value to $380,000. When his sister received the property in 2021, the property’s cost basis reset from $300,000 to $380,000. As a result, when she sold the property in 2022 for $400,000, only $20,000 of the sale (the difference between the sale price and the new cost basis) was subject to capital gains tax, not $100,000. This is just a small example of how a step-up in basis can save you a significant amount of money with capital gains taxes. Imagine a property bought for $20,000 over 80 years ago that has passed down through four generations and is now worth $500,000 at the most recent owner’s death. The new heir will not only inherit the property, but a significant savings in capital gains taxes as well.

Before we move on to spouses, one final point needs to be made here. The ability to use a step-up in basis with inheritances is a major reason why an individual would give their real estate property as an inheritance rather than a gift. When given as a gift, there is no step-up in basis for the new owner. That being said, there may be other reasons for gifting a property that are outside the scope of this article and, as we will soon find out, there may even be reasons to gift a property to actually increase one’s step-up in basis.

The rules for the step-up in basis get more complicated when a surviving spouse is involved. While there are several instances in which a spouse may get a full step-up in basis, there are also instances which may result in a surviving spouse only get a half step-up in basis. The reason for this is that the step-up in basis only applies to assets that are considered a part of a decedent’s estate. In reality, the determination of the step-up in basis with spouses is based on a variety of factors. Here are some of those factors that can affect the determination of a spouse’s step-up in basis:

• When the property was acquired

The date the property is acquired may impact the step-up in basis of a property for a surviving spouse. For properties purchased on or before Dec. 31, 1976, the previous law required joint property owners to keep track of the amount that each person contributed to purchasing the property. If both parties contributed to the purchase of the property, then the surviving spouse is only entitled to a half step-up in basis. However, if it can be proven that the decedent was the only one to fund the purchase of the property, then a spouse could receive a full step-up in basis for the real estate.

• State of residence

The step-up in basis may differ depending on whether or not you and your spouse reside in a community property state or a common law state. For common law states, spouses are considered joint tenants with rights of survivorship (JTROS). This basically means that when a spouse dies, the surviving spouse automatically owns the asset. However, in common law states, jointly owned assets are still treated as “separate property” for purposes of estate administration. Because of this property right designation upon death, spouses only receive a step-up in basis for the one-half of the property that is considered the decedent’s while the surviving spouse’s 50% of the property will remain at its original cost basis since nothing has effectively changed.

Certain states are considered community property states. These states hold that property acquired during the marriage (other than through gift or bequest) is considered community property. That means that a piece of real estate, regardless of how it is titled, is community property and is considered to be owned 100% by each spouse. Since both spouses are considered 100% owners, the entire asset is included in their estate. As a result, in community property states a surviving spouse is entitled to a 100% step-up in basis. In a limited number of common law states (currently Alaska, South Dakota, Kentucky and Tennessee) you can take steps to place assets in a community property trust. Those assets will be treated as community property, including providing the surviving spouse with a 100% step-up in basis.

• How the property is titled

Another factor is how the property was titled when one’s spouse passed away. This is especially relevant in common law states that treat the property as it is actually titled. If the property is solely in the decedent’s name, then the entire property is considered part of their estate. If the spouse is the beneficiary of the real property they are entitled to 100% of the step-up in basis. For this reason, sometimes spouses who have jointly held property will transfer the title solely in the name of the spouse who is anticipated to pass away first. If this occurs as anticipated, this decision can net the surviving spouse significant tax savings if they later decide to sell the property. However, before making this decision, there are three important things to consider. First, if the spouse dies within a year of the transfer, they are only entitled to the standard 50% step-up in basis. Second, consider the fact that if you are the transferor, you are relinquishing control of how that asset is used or bequeathed. Thirdly, this is not a good strategy if your spouse is planning to qualify for Medicaid eligibility.

Now that we understand the various factors that can impact a step-up in basis, it’s time to figure out how to properly calculate it. To make things even more complicated, these factors are not independent of each other. Here are a few scenarios to help you understand how a spouse’s step-up in basis may be calculated:

• Scenario 1 – Property acquired prior to 1977 (mutually funded)

Husband and wife, who live in a common law state, get married and purchase a property in 1975 for $30,000. In 2010, the husband passes away, and the property, which is now valued at $400,000, is transferred solely in his wife’s name. If the husband and wife both contributed money to purchase this home, then the wife would be entitled to a step-up in basis for only 50% of the property. That means the cost basis of 50% of the property would go from $15,000 to $200,000 while the other 50% would remain at the original cost basis ($15,000). If the property were to be immediately sold for $400,000, the wife’s cost basis would be $215,000 resulting in an obligation to pay capital gains taxes on $175,000.

• Scenario 2 – Property acquired prior to 1977 (solely funded by decedent spouse)

The facts of Scenario 1 remain the same except for the fact that the purchase of the house was solely funded by the decedent even though the property was titled jointly. In this scenario, the surviving spouse will get a full step-up in the basis of the property. The $30,000 cost basis is now reset to $400,000, and if the property were sold at that value, the spouse would not have to pay any capital gains taxes.

• Scenario 3 – Community states windfall

As we previously discussed, property acquired after 1976 in which the property is titled jointly will largely depend on the state where the property is located. That is, in common law states, the surviving spouse will get a step-up in basis, but only for the half of the property they inherited. Meanwhile, community property states allow the surviving spouse to get a full step-up in basis. In community states, even if the property is titled only in the name of the decedent spouse, if the surviving spouse is the transfer-on-death (ToD) beneficiary, then they will receive a full step-up in basis. So here is the community property windfall scenario. During the marriage, a husband solely funded and acquired a piece of property for $100,000 that, because of the state they live in, is considered community property. His spouse passed away before him, and at the date of her death, the property was valued at $250,000. Even though he acquired the property by himself, if his spouse were to die first, he would still be entitled to a 100% step-up in basis. In a common law state, there would be no step-up in basis at all since the property was only ever in the surviving spouse’s name.

Whether you are planning your estate, in the process of handling another’s estate or are a beneficiary, it is important to understand how real estate is valued when it is transferred to a beneficiary. There are ways to hold property and structure your estate that can result in significant tax savings to your beneficiaries. In some instances, there are proactive steps you can take to save your loved ones from incurring unnecessary taxes.