man enters rental property that just received a step up in basis after his partner died

Key Points:

  • You will generally receive a step-up in basis on your partner’s assets after their death, including their portion of jointly owned real estate.
  • Depreciation can offset rental income from real estate during the asset’s time period, but will be recaptured with a max 25% tax when you sell the property.
  • A decedent’s portion of accumulated depreciation is generally lost when a property gets a step-up in basis, and a new depreciation schedule must be started upon the inheritance.
  • Carryover losses can be used in the year of the owner’s death to offset income, but will not be carried forward post decedent’s death. 

John and Jill are married and have held a rental property jointly in a separate property state for 10 years. They bought the property at a value of $100,000 and have taken depreciation totaling $36,364 and carryover losses of $15,000. John is worried that when he dies, Jill will have to recapture the full amount of depreciation upon selling and that she won’t be able to use any of the carryover losses in the years following his death, possibly causing a tax burden of thousands of dollars. 

Fortunately, the “step-up” in basis allows for John’s portion of the deprecation to become zero after his death and likely means that Jill will be able to use her share of carryover losses in future years. John’s share of the real estate property will also get a step-up in basis reducing future capital gains on a future sale.

If this sounds like a foreign language from a galaxy far, far away, don’t worry. We’ll explain the terms depreciation, step-up in basis, and carryover losses in this article.

*This article is educational in nature and is not tax advice. Please speak with your CPA or Certified Financial Planner TM  about your personal situation.

What is step-up in basis?

When an owner of appreciated property dies and their heir(s) inherit the property, the basis of the property that the heir(s) inherit is not the basis of the original owner. Generally, the fair market value (FMV) of the property as included in the original owner’s estate becomes the new basis of the property for the heir(s), effectively “stepping up” the basis to the new fair market value. If instead the property value is below the original basis of the property, the original basis less any adjustments becomes the new basis for the heir(s), allowing them to sell the property without a large tax burden and possibly creating losses that they can use to offset other income.

For property held individually, this is relatively simple in both community and separate property states. The property generally receives a full step up in basis, making the FMV on the date of death the new basis of the property for the inheritor. 

Jointly held property can be trickier, especially in separate property states. If you live in a community property state, reach out to your attorney or CPA to see how the step up in basis applies to your property.

For most jointly held properties, each spouse owns 50% of the property and is responsible for 50% of the property’s basis. Because only the decedent’s share of the fair market value will be included in their estate, the step-up in basis will only apply to that portion of the property. Here is an example:

  • Daniel and Jill purchased a property for $100,000, and the fair market value of the property is now $400,000 after 15 years of ownership. 
  • Each spouse has a basis of $50,000. When Daniel dies, half of the property’s current market value will be included in his estate ($200,000) and becomes his new cost basis. 
  • Jill’s new basis includes her original basis ($50,000) plus the stepped up basis of Daniel’s portion ($200,000). Therefore, her new basis is $250,000.
  • She still has an unrealized gain of $150,000 in the property (total fair market value of $400,000 less her new basis). 

See our “Strategies for maximizing the step-up in basis” section below to see how you may be able to avoid leaving your spouse a property with unrealized capital gains.

Depreciation Recapture

Generally, the owners of a rental property can take depreciation deductions based on their basis in the property. There are multiple methods for calculating depreciation with the most common method being the straight-line method.

This is not tax advice. Please speak with your CPA regarding the correct depreciation method for your property.

You can use depreciation expenses to reduce the taxable income generated by the asset, which makes it a valuable tool throughout the life of the property. However, selling the property generally triggers a depreciation recapture tax at your federal income tax rate, with a max of 25%. Also, depreciation reduces your basis in the property, so you will generally have a higher gain in the property when selling. Here is an example of how this may play out.

  • Sally purchased a rental property for $100,000 five years ago, and it now has a market value of $350,000. 
  • She took straight line depreciation deductions each year she owned the property, totaling $18,181.82 ($100,000 / 27.5 x 5 years). 
  • When she sold the property this year, she had to recapture the depreciation at her marginal tax rate of 22%, resulting in a tax payment of $4,000. 
  • Also, she will need to pay capital gains tax on the sale price minus her basis ($350,000 – $100,000 = $250,000), which is $37,500. In total, she owes $41,500 to the IRS.

Does this impact my spouse when I die?

The step-up in basis when one spouse dies can have a significant impact on the rental property’s tax outlook. Specifically, not only will the decedent’s half of the property receive a stepped up basis, but their half of the accumulated depreciation will also be wiped away by the stepped up basis. 

With the stepped up basis, the decedent’s share of the property no longer has any accumulated depreciation that needs to be recaptured by the spouse if they sell the property. Instead, the surviving spouse can begin a new depreciation schedule on the inherited property using the new basis. 

However, there is no impact to the surviving spouse’s original basis and depreciation. They can continue taking depreciation on their original basis over the remaining life of the property (generally 27.5 years from initial purchase). Let’s look at an example.

  • Daniel and Jill still own the rental property they purchased for $100,000 15 years ago.
  • Daniel passed away recently, and Jill is wondering how that will impact the property.
  • The fair market value is now $400,000, and they have taken $54,545 in depreciation over the 15 years. 
  • Daniel’s half of the Fair Market Value of the property receives a full step up in basis to $200,000, and his portion of the depreciation is wiped out. 
  • Jill’s new adjusted basis in the property is $222,727 ($200,000 + $50,000 – $27,272.50) after subtracting her half of the accumulated depreciation. She can continue taking depreciation of $1,818 per year on her half until it is fully depreciated in 12.5 years. 
  • She can also begin taking depreciation on the stepped up portion of the basis, or $7,273 annually ($200,000 / 27.5). 

If Jill wanted to sell the property immediately after Daniel’s death, she would be recognizing a total gain of $177,273 on the property (the fair market value of the property – Jill’s new basis). Of that amount, Jill would pay depreciation recapture taxes on her $27,273 of accumulated depreciation, and capital gains tax on the remaining $150,000. 

If the deceased spouse owned the property outright, the property would receive the full step-up in basis and the accumulated depreciation would be fully wiped out, leaving the surviving spouse with no unrealized capital gain and no depreciation to be recaptured if they sell the property immediately. 

Strategies for maximizing the step-up in basis

While risky, you may consider having a real estate asset titled in only one spouse’s name or held in one spouse’s revocable trust. This would maximize the step up in basis and wipe out all depreciation at that spouse’s death. However, this is highly dependent on the owner predeceasing the other spouse, otherwise you may be stuck with a highly appreciated asset with a lot of depreciation to be recaptured. This would likely be a strategy you would only employ if your intention is to pass the property to heirs, as even non-spouse heirs can benefit from the stepped up basis. 

Similar to above, if you already hold the property jointly, you can transfer your portion to your spouse if it becomes clear that they are likely to predecease you. At the time of writing (2023), there is no penalty or taxes associated with transferring assets to your spouse, so they would now own the property outright with the full original basis of the property. At their death over a year later, you would inherit the property with a full step-up in basis and no depreciation to recapture. It is important to note that if they die within one year of the transfer, there would be no step-up in basis on the transferred portion of the asset, leaving you effectively where you would have been if you did not transfer the asset in the first place, but not worse off. 

In general, if you would like to avoid paying capital gains and depreciation recapture taxes, you can hold the property until you pass the property to your heirs at death. 

Capital gains and depreciation recapture are only due when you sell the property, so highly appreciated or highly profitable properties may be better off passing to your heirs with a full step-up in basis. 

However, don’t let the tax tail wag the dog. If your property isn’t profitable, run the numbers on alternative investment options.

Don't let the tax tail wag the dog Spark Financial Advisors

Don’t let the tax tail wag the dog. Your real estate property should be profitable.

This is general information only. This is not tax advice. Please consult with your tax advisor regarding your specific tax situation and real estate properties.

What about carryover losses?

With a real estate property, large depreciation deductions may offset your income so much that you end up with net losses for federal income tax purposes. Because rental property is generally considered passive income, you may be limited in what income you can offset. Losses remaining after offsetting any available income can generally be carried over into future tax years. These can be very powerful by offsetting income from the property in future years, but what happens when one spouse dies?

Generally, income and losses from a jointly owned property are split between the owners from a tax perspective, so each spouse is responsible for half of any carryover losses on the property. 

At death, carryover losses are lost and are not passed on to heirs.

For spouses, this means the deceased spouse’s portion of carryover losses is lost at their death, but the surviving spouse still has the losses on their portion. However, there is one silver lining to this equation. 

The deceased spouse’s carryover losses can be used to offset income in the year of their death. Because of this, those carryover losses should be used wherever possible. This may mean generating additional income in rental properties to be offset, even if it is specific to that tax year.

The contents above should not be construed as financial or tax advice. Please consult your tax advisor before making any changes. 

Careful planning and utilization of the step-up in basis can save your spouse thousands of dollars if they sell the property and may even allow your heirs to sell the property tax free. Although a portion of the carryover losses of the property may be lost for the years following your passing, your spouse has an opportunity to generate rental income in the year of your death to use the remaining carryover losses before they are gone.

We understand that it can be very difficult to think about finances after losing a loved one. Book a call with us today if you would like to know how to implement these strategies into your financial plan.

The contents above are for educational purposes only and should not be construed as financial or tax advice. Please consult your tax advisor before making any changes. 

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