Stepped-Up Basis at Death for Rental Real Estate: A Guide for Tax Professionals

When a spouse passes, jointly owned rental property typically qualifies for a stepped-up basis on the deceased spouse’s share under IRC §1014(a). This adjustment is crucial for ensuring accurate depreciation calculations and minimizing errors on future tax filings. Unfortunately, many tax professionals overlook this adjustment, particularly for depreciation, leading to potential errors that can affect clients’ financial outcomes. Here’s a breakdown of the process, the rules, and why proper calculations are essential.

Example Scenario: Jointly Owned Rental Property
•Married Couple: John and Mary jointly own a rental property with a basis of $300,000.
•Fair Market Value at Date of Death: $500,000.
•John passes, and Mary inherits John’s 50% interest in the property.

Step 1: Determining the Stepped-Up Basis

Under IRC §1014(a)(1), the inherited 50% interest in the rental property receives a step-up in basis to its fair market value (FMV) at the date of John’s death. Mary’s new basis is calculated as:
•Mary’s original 50% ownership (no step-up): $150,000.
•John’s stepped-up basis for the inherited 50% interest: $250,000 (50% of FMV).

Mary’s Total Basis After Adjustment: $400,000 ($150,000 + $250,000).

Step 2: Adjusting for Depreciation

The stepped-up basis must be depreciated separately from the original basis. Here’s how to calculate and apply depreciation:
1.Original Basis Depreciation: Mary continues to depreciate her original $150,000 (50% of $300,000) over the remaining useful life of the property.
2.Stepped-Up Basis Depreciation: The stepped-up basis of $250,000 must be depreciated as a new asset starting on the date of death over the appropriate class life, typically 27.5 years for residential rental property under IRC §168(c).

Step 3: Depreciation Recapture Upon Sale

When Mary sells the property, depreciation recapture applies differently:
•Depreciation claimed on the stepped-up basis is not subject to recapture. This is because the stepped-up basis is treated as new property under IRC §1014(a).
•Depreciation claimed on the original basis remains subject to recapture under IRC §1250.

Step 4: Correcting Errors in Depreciation

If depreciation adjustments for the stepped-up basis were not properly applied, you can correct them using a Section 481(a) adjustment. This adjustment allows taxpayers to account for prior missed depreciation deductions in the current year without amending prior returns, provided it meets the requirements under Rev. Proc. 2015-13.

Why Proper Basis Calculation Matters

Accurately applying the step-up and proper depreciation has several benefits:
1. Tax Minimization: Ensures that depreciation deductions are maximized for the client.
2. Avoiding Overstatement of Gain: Without proper adjustments, the gain on sale may be overstated, resulting in overpayment of tax.
3. No Recapture on Stepped-Up Basis: By correctly claiming depreciation on the stepped-up portion, clients avoid unnecessary recapture taxes on that portion.

Notes for taxpayers in Community Property states

In community property states, the death of one spouse often results in significant tax benefits for the surviving spouse, particularly concerning the step-up in basis. Community property rules govern how property is owned and treated for tax purposes, and these rules differ from those in common law states.

Community Property States

The nine community property states are:

• Arizona

• California

• Idaho

• Louisiana

• Nevada

• New Mexico

• Texas

• Washington

• Wisconsin

Additionally, Alaska allows couples to opt into community property treatment by agreement.

Key Impact of a Spouse’s Death in Community Property States

1. Full Step-Up in Basis

Under IRC §1014(b)(6), in a community property state, when one spouse dies, the entire property (not just the deceased spouse’s half) receives a step-up (or step-down) in basis to the fair market value (FMV) at the date of death. This rule applies regardless of who inherits the deceased spouse’s share.

Example:

• John and Mary own rental property as community property with a total basis of $300,000.

• FMV at John’s death: $600,000.

• The entire property’s basis is stepped up to $600,000, and Mary can use this as the new starting point for depreciation and gain calculation.

This differs from common law states, where only the deceased spouse’s share typically receives the step-up.

Relevant Case Law and References
1. IRC §1014(a): Provides the rule for stepped-up basis at death.
2. IRC §168(c): Establishes the class life and depreciation rules for rental property.
3. IRC §1250: Governs depreciation recapture for real property.
4. IRS Publication 527: Offers guidance on depreciation and basis adjustments for rental property.
5. Case Law Example: Adams v. Commissioner, 85 T.C. 359 (1985) — Reinforces proper allocation of basis and depreciation adjustments.

Conclusion

Tax professionals must ensure accurate stepped-up basis calculations and apply depreciation adjustments correctly when one spouse passes. These adjustments are critical for minimizing taxes on sale and avoiding depreciation recapture issues. If prior errors exist, leverage Section 481(a) adjustments to bring depreciation in line.