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What is the Cost Basis of an Inherited House?

Published in Inherited Property Basis 5 mins read

The cost basis of an inherited house is generally its fair market value (FMV) on the date of the decedent's death. This rule applies regardless of whether the executor of the estate files an estate tax return (Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return).

Understanding Cost Basis for Inherited Property

Cost basis is a fundamental concept in taxation, particularly when it comes to selling assets like real estate. It represents the original value of an asset for tax purposes, from which gains or losses are calculated upon its sale. For inherited property, the rules are specifically designed to provide a significant tax advantage known as a "step-up in basis."

The "Step-Up in Basis" Rule

Unlike property that is gifted during someone's lifetime, inherited property receives a step-up in basis. This means the cost basis is adjusted to the fair market value (FMV) of the property on the date of the original owner's death, rather than carrying over the deceased's original purchase price. This adjustment can significantly reduce or even eliminate capital gains tax if the property is sold shortly after inheritance, as the basis is updated to a value closer to its selling price.

For example, if a parent bought a house for $50,000 many years ago and it was worth $400,000 at the time of their death, the inheritor's cost basis becomes $400,000. If they then sell the house for $410,000, their taxable capital gain is only $10,000 ($410,000 sale price - $400,000 stepped-up basis), not $360,000 ($410,000 - $50,000).

Alternative Valuation Date

In some cases, if the executor of the estate chooses, an alternative valuation date can be used. This date is generally six months after the date of death, but only if both the value of the property and the total value of the gross estate decrease. This option is typically considered only for large estates subject to estate tax where a lower valuation could reduce the tax liability. For most inherited properties, the fair market value on the date of death is the standard.

Why Basis Matters: Capital Gains and Losses

The cost basis is crucial because it directly impacts the calculation of capital gains or losses when the inherited house is eventually sold.

  • Capital Gain: If you sell the house for more than its adjusted cost basis, you will realize a capital gain. This gain is generally subject to capital gains tax.
  • Capital Loss: If you sell the house for less than its adjusted cost basis, you will realize a capital loss. Capital losses can be used to offset capital gains and, to a limited extent, ordinary income.

The step-up in basis rule provides a substantial benefit by resetting the clock on appreciation, potentially saving inheritors thousands in capital gains taxes.

How to Determine Fair Market Value (FMV)

Establishing the correct fair market value on the date of death is critical for determining the inherited property's basis.

  • Professional Appraisal: The most common and reliable method is to obtain a professional appraisal of the property as of the decedent's date of death. An appraiser will assess the property's condition, features, and recent sales of comparable properties in the area.
  • Estate Tax Returns (Form 706): If the estate was large enough to require filing an estate tax return (Form 706), the value listed on this return for estate tax purposes will generally be accepted as the fair market value for basis purposes.
  • Comparative Market Analysis (CMA): A real estate agent can provide a comparative market analysis, which gives an estimated value based on recent sales, though this is less formal than a professional appraisal and may not hold up as strongly for tax purposes.
  • Official Records: For properties that were part of an estate undergoing probate, there might be official valuations or court-approved appraisals available.

It's important to have documentation to support the determined FMV, especially if you plan to sell the property in the future.

Key Differences: Inherited vs. Gifted Property Basis

Understanding the distinction between inherited and gifted property is vital, as their cost basis rules differ significantly.

Feature Inherited Property Gifted Property
Cost Basis Fair Market Value (FMV) on date of decedent's death (step-up in basis) Donor's original basis (carryover basis)
Capital Gains Significantly reduced or eliminated due to higher basis Potentially higher capital gains due to lower basis
Estate Tax May be subject to estate tax depending on estate size Generally not subject to estate tax at time of gift

This table highlights why inheriting property often provides a more favorable tax outcome regarding basis than receiving a gift.

Practical Considerations and Tips

  • Maintain Records: Keep all documentation related to the inherited property, including the decedent's death certificate, estate documents, any appraisals conducted for the estate, and records of any capital improvements you make after inheriting the property.
  • Adjustments to Basis: The basis of an inherited house can be further adjusted. For instance, the cost of substantial improvements you make to the property (e.g., adding a room, replacing a roof) increases your basis, while depreciation claimed (if it was a rental property) decreases it.
  • Consult Professionals: Navigating the complexities of inherited property and its tax implications can be challenging. It's often beneficial to consult with a tax advisor, estate attorney, or financial planner to ensure you correctly determine the basis and comply with all tax obligations. Resources like the Internal Revenue Service (IRS) provide detailed guidance on these topics.