From an income tax perspective, we are often concerned with a person’s “basis” (or “cost basis”) in property. In basic terms, a person’s “basis” in property is the original cost of the property. When property is sold, income tax may be imposed on the difference between a person’s basis and the amount he or she received in the sale. This difference results in a gain (often called a “capital gain”) that may be subject to income tax. Therefore, generally speaking, the higher one’s cost basis in certain property, the lower one’s taxable gain will be, resulting in a lower income tax bill. So, high basis = good; low basis = bad.
When someone dies, the property that person leaves as a gift to others receives a “step up” in basis to the property’s fair market value on the date of death. For example, your favorite aunt just left you a house valued at $250,000 in her will. You learn that your aunt purchased this house in 1975 for $30,000. So, your aunt’s original cost basis in this house is $30,000. Well, because you received this property in your aunt’s will, you inherited the house, but (thankfully) you did not inherit her low basis. Your basis is “stepped up” to $250,000, which was the house’s fair market value at her death. Therefore, when you ultimately sell this house, you get to use your fresh, new basis of $250,000 to calculate your gain for income tax purposes, which can save a bundle on taxes. In fact, if you were to immediately sell this house for $250,000 to an eager buyer, your taxable gain would be a grand total of $0.00.
To really point up the significance of this “step up” in basis rule, imagine your favorite aunt had instead gifted this house to you one day before she died. Under this scenario, you would be forced to use your aunt’s original basis of $30,000 (called a “carry over” basis) when calculating gain on the sale. That same transaction above with our eager buyer has now resulted in a taxable gain of $220,000, all of which may be subject to income taxes. That’s a good day for the IRS, but not so much for you.
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