Stepped-Up Basis is what makes all of the deferred taxes on the Capital Gains and the Depreciation Recapture go away. This happens when you pass your property to your heirs. Stepped-up Basis turns “tax-deferred” into “tax-free.”
BASIS IN REAL PROPERTY
If you own real estate, you have a “Basis” in that property. This is true of all real estate assets. Figuring your Adjusted Tax Basis is the most important calculation when understanding your tax liability prior to selling real estate. This figure may change over the period of time during which you owned the property. Capital Improvements and Depreciation are typical factors that may affect your basis during such time period. Having a basis in real property is how the IRS keeps track of your gain (profit) on the real estate you own. When selling, you either do a conventional sale and are subject to paying the gains and depreciation recapture taxes, or you engage a 1031 exchange by rolling your basis into another property and avoid paying all the taxes.
STEPPED-UP BASIS IN PURCHASED PROPERTY
If you purchased a Duplex for $360,000 today, your Basis in that property is what you paid for it, plus any costs of acquisition.
If your cost of acquisition was $10,000, then your Basis in the property is $370,000.
If you spend $30,000 improving the property, then your Basis in the property becomes $400,000.
If you rent out the property, which you will, you will claim an annual depreciation allowance, and deduct that amount from your rental income.
But first you must determine something called your Depreciable Basis, because all of the $400,000 property is not depreciable.
The land on which the building is sitting is not depreciable, so you must separate out the value of this portion. Let’s assign $50,000 to the value of the lot.
That leaves a Depreciable Basis in the property of $350,000 which can be depreciated over a period of 27.5 years resulting in an annual depreciation allowance of $12,727. (27.5 years for Residential & 39 years for Commercial property)
After you have rented the Duplex for five years and claimed $50,000 in depreciation allowance, your Basis in the property is $300,000.
So, for property that you purchased, your Basis in the property will be the purchase price, plus cost of acquisition, plus cost of improvements, and minus depreciation allowed.
CONCLUSION
Stepped-up Basis turns “tax-deferred” into “tax-free” and is only available for inherited property. Stepped-up Basis is one of the three best concepts in the Tax Code for the real estate investor. The other two are Section 121 and Section 1031. Using all three is the ultimate lifetime investing plan.