When it comes to transferring property, the method of transfer—whether as a gift or an inheritance—can have significant tax implications. Understanding these differences is crucial for both the giver and the recipient. This article will delve into the meaning of basis, taxation differences between selling a gift property or an inherited property and provide comparative examples. We will also discuss the different inherited results based on how the title is held and a list of community property states. The article includes a discussion related to inheriting property that had been previously gifted.
Basis, The Foundation of Property Taxation - The term "basis" refers to the value used to determine gain or loss for tax purposes when property is sold. The basis is generally the cost of the property, including purchase price and any associated expenses. However, the basis can be adjusted for various reasons, such as improvements made to the property or depreciation.
- Gift Basis - When property is received as a gift, the recipient's basis is the same as the giver's basis. This is known as a "carryover basis." For example, if a parent gifts a home to their child, and the parent's basis in the home is $100,000, the child's basis will also be $100,000, regardless of the home's current market value. But see “Holding Period Gifted Property” below for an exception to the carryover basis rule.
- Inherited Basis - When property is inherited, the recipient's basis is generally the fair market value (FMV) of the property at the date of the decedent's death. This is known as a "step-up in basis,” although it is possible for there to be a step-down in basis. For example, if a parent passes away and leaves a home to their child, and the home's FMV at the time of death is $300,000, the child's basis will be $300,000. If the parent’s basis was $400,000 but the FMV at their death is $300,000, the child’s basis will be $300,000, an example of a step-down in basis.
When the value of the decedent’s estate exceeds the estate tax exemption ($13,610,000 in 2024) and a Form 706, Estate Tax Return, is required, the decedent's estate may elect to use an alternate valuation—determined six months after the date of death, or if earlier, the date the property is actually sold, exchanged, or distributed by the estate. This alternate valuation date is not available to estate’s valued at less than the exemption amount.
Taxation Differences: Selling Gifted vs. Inherited Property - The basis of the property significantly impacts the amount of capital gains tax owed when the property is sold.
- Selling Gifted Property: If the recipient sells the gifted property, the capital gain is calculated based on the difference between the sale price and the carryover basis. For example, if the child sells the gifted home for $300,000 and their basis is $100,000, the capital gain is $200,000, which is subject to capital gains tax.
- Selling Inherited Property: If the recipient sells inherited property, the capital gain is calculated based on the difference between the sale price and the stepped-up basis. For example, if the child sells the inherited home for $300,000 and their basis is $300,000, there is no capital gain, and therefore no capital gains tax is owed. In fact, there could be a tax loss in this example once selling expenses are considered.
- Holding Period Gifted Property – For gifted property, the holding period of the gift giver (donor) is tacked on to the gift recipient’s holding period, unless the FMV of the gifted property is less than the donor's basis. In that case the recipient’s basis for loss purposes is the property's FMV. Thus, if the recipient sells the property at a loss, the holding period does not carry over because basis is determined by reference to fair market values and not to the donor's basis.
- Holding Period Inherited Property – Property acquired from a decedent automatically has a holding period of more than one year. Thus, the individual who inherits that property can benefit from the lower long-term capital gains tax rates when selling the property even if they don’t themselves hold the property more than a year.
Inherited Results Based on Title Holding - The way property is titled can affect the basis adjustment upon inheritance.
- Joint Tenancy: When property is held as joint tenants, the surviving joint tenant receives a basis adjustment only on the inherited portion of the property. For example, if two siblings own a property as joint tenants and one passes away, the surviving sibling receives a basis adjustment on the deceased sibling's half while retaining their own basis on the other half.
- Community Property: In community property states, when one spouse dies, the surviving spouse receives a basis adjustment to the FMV for both the deceased spouse's half and their own half. This results in a full step-up in basis for the entire property.
Community Property States - The following states are community property states:
- Arizona
- California
- Idaho
- Louisiana
- Nevada
- New Mexico
- Texas
- Washington
- Wisconsin
Gift Tax Considerations
- Gift Tax Exclusion: An annual exclusion amount allows the giver to gift up to a certain amount per recipient each year without incurring gift tax. The exclusion is adjusted for inflation annually and is $18,000 for 2024.
- Gift Tax Return: If the value of the gifted property exceeds the annual gift tax exclusion amount, the giver must file a gift tax return (Form 709).
Depreciation and Business Property - For inherited business property or rentals, the accumulated depreciation on the inherited portion of jointly owned property is reset. The beneficiary restarts the depreciation from scratch on the inherited portion, which can be beneficial for tax purposes. For assets held as community property, all the prior depreciation is disregarded as of the date of death and the depreciation for the surviving spouse starts over using the inherited basis.
Inheriting Gifted Property - Inheriting gifted property involves several tax implications and considerations, particularly concerning the basis of the property. Here’s a detailed discussion on the topic:
- Basis of Gifted Property - When an individual receives a gift of property, the basis of the property for the recipient is generally the same as the basis of the property in the hands of the giver. This means that the recipient does not receive a step-up in basis to the fair market value (FMV) at the time of the gift. Instead, they inherit the giver’s original basis.
Example: If a parent gifts a home to their child, and the parent’s basis in the home is $100,000, the child’s basis in the home will also be $100,000, regardless of the home’s FMV at the time of the gift.
If the recipient of the gifted property subsequently passes away and the original giver inherits the property back, the basis of the property can be adjusted, but specific rules apply. IRC Section 1014(e)
- Holding Period Requirement: The recipient of the gift must hold the property for at least one year before their death for the original giver to receive a basis adjustment.
- Basis Adjustment: If the recipient dies within one year of receiving the gift, and the property is inherited back by the original giver (or the spouse of the original giver), the basis of the property in the hands of the original giver will be the same as it was in the hands of the decedent immediately before their death. This means there will be no step-up in basis to the FMV at the time of the recipient’s death.
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Examples:
- Scenario 1: Parent gifts a home to their child. The child holds the home for more than one year and then passes away. The parent inherits the home back. The parent’s basis in the home will be adjusted to the FMV at the time of the child’s death.
- Scenario 2: Parent gifts a home to their child. The child passes away within one year of receiving the gift. The parent inherits the home back. The parent’s basis in the home will be the same as it was in the hands of the child immediately before their death (i.e., the original basis).