“Step up basis” is an important concept for real estate investment and both new real estate investors and those seasoned in the industry. While it may sound like technical accounting jargon, understanding the mechanics can give you an edge when analyzing the economic and tax impacts of a potential real estate deal.
First, “basis” is essentially another word for the amount you have invested in an asset. If you buy a house today for $250,000, your cost basis is $250,000. It is common for your basis in business property to decrease each year as depreciation deductions are taken, so your basis in business real estate will generally decrease over time.
Real estate is often held in a partnership. When you purchase, invest, or inherit an interest in a real estate holding partnership, the value of the interest may be very different than the underlying tax basis of the assets. You may think your basis is one value, when your tax basis is really something much less. In both cases (purchase or inherit), the underlying property is not being sold or purchased, yet the owner is new. The IRS has put a mechanism in place to allow you to “step up” your basis to the value of the interest.
1. Tax deductions: you can claim depreciation deductions on the additional basis each year going forward, sometimes resulting in tens of thousands of dollars in tax savings. If you were forced to keep the original step up basis, it’s possible that all deductions had already been exhausted.
2. Tax upon sale: Tax on the sale of real estate is determined by the amount of profit or gain on the sale. The step up in basis allows you to use the new, higher basis which results in lower gain and a lower tax bill upon sale.
As an example, imagine you inherit an office building held through a partnership from a family member upon their passing for which they had originally paid $50,000 but is now worth $150,000. Now imagine you sell this property a few months later for $150,000. Without a step up in basis, your basis in the partnership assets would be only $50,000 and you would owe tax on the $100,000 gain.
However, if you apply the step up rules, your new basis would become the $150,000 value and your gain on the sale would be zero, resulting in a zero tax bill.
These huge tax savings are important to consider when looking at a potential deal. Tens of thousands of dollars in taxes could quickly change your potential cash flow. Being aware and proactive can help you make quicker decisions when an opportunity arises.
The step up basis doesn’t happen automatically and must be calculated and documented on the partnership tax return. It’s worth the call to your Mortgage Advisor to ensure it’s done correctly. You don’t need to know exactly how it works; use your Mortgage Advisor as an integral part of your team to help you identify tax saving opportunities.
Written by: David Olson