“I’ll take the house, but it’s better if you leave it in your will”: The Tax Consequences of Grandma’s Devise

 

This guest post is from Dana DiDomenico, Regent Law 3L and current Wills, Trusts, & Estates student:

What happens when grandma leaves you the house? It’s an awkward thing to say, but typically the tax consequences of devising something to your children is better than a straight sale or outright gift. This is partly due to something called a “step up” basis. At base level, when determining the tax consequences of the sale of a home, a taxpayer must calculate their adjusted basis (the original cost of the home plus any cost for home improvements) minus the amount realized (the sale price). This will give the taxpayer a number that is their approximate gain, or loss, for the sale, which will be taxed as income to the taxpayer. See Internal Revenue Code (IRC) §§ 1012; 1016. Generally, real property appreciates in value, which may cause problems for the humble tax avoider.

To demonstrate, let’s say your grandmother bought a piece of property in upstate New York several years ago. At the time, she only paid $10,000 ($4,000 for the land, $6,000 for the house). Several years later, property prices have gone up and Grandma sells the house for $100,000, the fair market value at the time. Grandma will have a realized gain of $90,000 ($100,000 - $10,000). Grandma will have to pay taxes on that $90,000 gain to the Internal Revenue Service (“IRS” – or Voldemort). If Grandma were to die, sorry grandma, before that tax filing day, all of that extra tax would come directly out of her estate.

What if Grandma, out of kindness, decides that instead of selling the property she’s going to give it as a gift to her daughter? Under IRC § 1015, this will result in largely the same tax consequences as if Grandma herself sold the property. This result is called “transferred basis” and it means that the daughter retains Grandma’s basis in the property ($10,000) once the gift is complete. This yields that same $90,000 tax consequence for the daughter once she sells it. Let’s try this again, this time using IRC § 1014. Grandma bought a house in upstate New York for $10,000. Now, instead of selling the house, she meets with an attorney and drafts a will (or even a revocable living trust) devising it to her daughter, “to help her raise the next generation of Sicilian-Americans,” she says. What result? Well, the Daughter has a better tax consequence, for one. This is because of what’s called “step up” basis. When Grandma devises the property, her initial basis (the $10,000) is “stepped up” to the fair market value at the time of the decedent’s death. Thus, when the daughter inherits the property and subsequently sells the property, her new basis will be $100,000 (the fair market value) instead of $10,000. If the Daughter then sells the property for, let’s say $110,000, the daughter will only be paying tax on the recognized gain – that is, $10,000.

These different outcomes are exactly why estate planning is so incredibly important. While these concepts are simplified for the purposes of this article, with the exclusion of issues such as mortgages and equity deductions, the overall premise is at the heart of tax planning. Tax avoidance is a good thing, and a good attorney will help you make the most of it for your family.