Understanding the concept of “step-up in basis” becomes crucial when dealing with inherited property and its tax implications. Here’s a simplified breakdown:
Significance of Step-Up in Basis
The concept of step-up in basis holds importance for individuals inheriting property who aim to minimize taxes when selling it. A step up in basis resets the property’s tax basis to its market value at the time of inheritance thereby reducing the capital gains tax burden. In California, despite Proposition 19 affecting property tax reassessment, the step-up in basis for capital gains tax remains unchanged. This rule is advantageous for California residents, including those residing in San Diego.
Example: Suppose your family originally purchased a property for $100,000, which now holds a value of $500,000. In such a scenario, you would normally owe taxes on the $400,000 increase in value. However, with a step up in basis adjustment the property’s value is reset to its market value at the time of inheritance. If you then sell the inherited property for $500,000 the adjustment would mean that you won’t incur any capital gains taxes on that sale.
Eight Common Mistakes to Avoid:
- Neglecting to Get an Appraisal – Failing to appraise a property at the time of inheritance can lead to disagreements with tax authorities and can result in tax audits.
- Lack of Understanding of Step-Up in Basis – Not being aware of the option of step-up in basis could result in unnecessary capital gains taxes. It’s advisable to educate yourself or seek advice from a tax professional to grasp how the step up in basis can work to your advantage.
- Misinterpreting Proposition 19 – Proposition 19 impacts property tax reassessments. Not the step-up in basis. Misunderstanding this difference might lead to tax planning errors. It’s crucial to comprehend how Proposition 19 affects your circumstances and plan accordingly.
- Mistakes in Calculating Capital Gains – Using the purchase price of the adjusted basis can lead to paying more taxes than necessary. Make sure to factor in the adjusted basis when working out capital gains.
- Lack of Understanding Regarding Holding Period – Inherited property is generally considered to have a term (one year or longer) holding period, making it eligible for lower capital gains tax rates when sold. Misunderstanding this concept could result in higher tax liabilities.
- Neglecting Detailed Documentation – Failing to keep records of the property’s value and relevant transactions can complicate tax reporting and potentially lead to disputes. It’s crucial to maintain records, including the property’s market value upon inheritance along with any upgrades completed at the property.
- Incorrect Distribution Among Beneficiaries – When dealing with beneficiaries, distributing the basis incorrectly can trigger tax complications. Allocate the basis among beneficiaries based on their ownership interests. Again, ensure there’s detailed supporting documentation.
- Failure to Seek Professional Advice – Trying to navigate intricate tax laws without expert guidance can lead to costly mistakes. It’s advisable to seek assistance from tax professionals versed in California’s real estate and inheritance regulations.
Types of Properties Covered: The increase in basis applies to all inherited real estate, including residential and commercial real estate.
Recent Case Study: One of our clients recently inherited a property with rents significantly below market value. Due to AB1482, California’s rent control law, raising the rents to market rates was not an option. When the property taxes were reassessed, the cash flow from the property decreased. Given the circumstances, the client decided it made more sense to sell the older building which had substantial deferred maintenance and below-market rents and reinvest in a property that was turnkey and achieving market rents. This strategic move provided the family with a better investment vehicle, offering a property with minimal maintenance expenses and strong cash flow.
This case study highlights how smart investment decisions can transform an inherited challenge into a lucrative opportunity, ensuring the family’s financial stability and peace of mind.
Disclaimer: This article does not replace advice from legal, financial, construction, zoning or tax professionals. The content is for educational purposes solely and is provided without warranties or representations.
Seth Watje & Adam Cairo are Principals at Starker West Inc, an independent, full-service commercial real estate brokerage firm that specializes in representation of clients in the acquisition and disposition of multifamily assets throughout San Diego County. For more information contact us at [email protected]/ [email protected] , 619-358-3748 or 619-300-0173 or on the web at WWW.STARKERWEST.COM