Stepped-Up Basis Explained – Will It Be Eliminated?

David Moore: Hello, David Moore with Equity Advantage. Today we’re going to talk about stepped-up basis. Now you might’ve been hearing a lot about this topic recently, because it was on the chopping block with President Biden’s initial tax proposals a year ago. Now, understand those tax proposals were pre-COVID. We’re in a different world than we were then, and we’re still waiting to see what happens with the actual bill when it comes out.

But if you combine the stepped-up basis and elimination of 1031, or a great reduction in who can use it, those are big things. And also increasing the capital gains tax rate once again is another item that’s out there. But that stepped-up basis situation is one of those things that’s a great opportunity for people today, because what happens in an Exchange, is you’ve got a tax deferral. It’s not tax elimination, so it’s a 1031 tax deferred Exchange. The basis gets carried forward, the gain gets carried forward. And imagine how much gain is being deferred through somebody’s life.

David Moore: Now, when we look at gain on a property, it’s just simply the difference between the adjusted sales price and the basis in the property. Your basis in the property is what you paid for it, plus capital improvements, minus depreciation. Now there’s lots of confusion in those three numbers, because imagine… I have to look at that acquisition price. I don’t know how the person bought the property.

If they pulled money out of their pocket, that purchase price is the initial number to calculate that basis from. If you were given a property, that number is really the basis on that property you are gifted. Your basis is going to be what the person granting that gift, it’s what their basis was. So that number could be dramatically different.

David Moore: Imagine if you did an Exchange into that property, you’ve got basis carry forwarding. Once again, it’s going to impact that initial number, that acquisition price. If you received it through inheritance, a stepped-up does one thing, gifting does another. Imagine if you look back far enough, pre-1997, we had Section 1034, the old residential roll over. Once again, you’ve got basis carry forward in that situation.

1034 used to read: if you sold a home, you had two years to buy a new home of equal or greater value. And as long as you did that, you had total deferral. If you’re 55 or older, you had a one time lifetime exclusion of $125,000 in gain. When the Universal Exclusion Section 121 came into play back then in ’97, those numbers, that 250 exclusion or 500 exclusion really meant something. In today’s world, I would say we’ve got a great number, tremendous number of people with homes with gains well in excess of those two numbers.

And it is probably debatable whether 1034 would actually be a more attractive thing than 1031. But all these things impact that basis. So how you received that property, how you got it. Did you pull money out of your pocket? The Exchange into it, 1033 is involuntary conversion. Once again, a basis carry forward. So that impacts that initial number. Now as I said, the basis is the purchase price, plus capital improvements, minus depreciation.

David Moore: I’m on the phone with people every day, talking about this stuff, trying to rationalize an Exchange for them, to justify it. I don’t want to waste somebody’s money. If they don’t have gains to justify a transaction or they’re doing something that might have a partial tax consequence, we want to understand where their basis is, so we can really decide where that Exchange makes sense. What’s the bottom line? How much needs to be deferred to rationalize a transaction? And I never make assumptions with our clients.

I’ve been doing this 30 years. I can remember a case where I had a CPA we were doing a transaction for. I think her tax hit was $5,000. The Exchange was going to be $1,000. I wouldn’t have done the transaction just because of the timelines involved. And she wanted to do it. She was not going to part with that $4,000.

On the other hand, I can remember a gentleman that was looking at an $800,000 tax hit, and he just didn’t care. He’s just like, “Look, I don’t want to do the transaction. Going to terminate the Exchange. I’ll just pay the 800. I’ve got the money to go use as I choose.”

David Moore: So I never make assumptions at what point an Exchange makes sense or ceases to make sense for a given investor. But we’re always looking at gain in this situation. So that purchase price, plus capital improvements during the time you owned it, what did you do with the property? And somebody, I’ll ask them, “Well, did you put a lot of money into the property during the time you owned it?” And they say, “Yes, we did this and this and this and this and this.” And those things maybe could have been capitalized, but did you write them off? They say, “Oh yeah, I wrote it all off.” Well, the expense of those items didn’t impact your basis. You capitalize them, it does. So you’ve got to look at what’s been done to the property during the time you own it.

Now we get to depreciation. You got a situation there where the government’s position is: you should have taken it, therefore you did. I’ve got people that I talked to, sometimes they don’t even take depreciation. They think, “Well, I’m not going to be saddled with that issue.” Well, if they got audited, they’re going to have a problem.

So it’s really important to understand who you’re working with, what they’re doing. And I would say your good tax people are one of your most important people on that investment team. Obviously, I’m going to throw myself in there. But good, competent tax and legal counsel, tax counsel, they’re the people that are going to be working with you year in, year out.

David Moore: I know you can do your own taxes. A lot of people do. If you don’t have any income properties, fine. You’re just an employee of some business, fine. You don’t need to have your own CPA, probably. But as soon as you start throwing investments into the mix, you need to have somebody there that’s going to take care of you. Their job is to keep your money yours.

And one of the things we always talk about is you’ve worked hard for your money. We work hard to keep it yours. Your CPA’s the same way. Their job is really keep your money yours, and keep it working for you. So expensing and capitalizing those expenses have different impacts. The reason I’m talking about that basis situation is ultimately, it triggers gain, right? So your basis, that number is subtracted from the adjusted sales price, giving you gain. 1031 defers that gain, Section 121, the universal exclusion of home sale, that’s a straight exclusion on gain.

David Moore: But if we’re looking at it, we start talking about stepped-up basis, you’ve got people that have worked their whole life deferring gains from one property to another, they pass away. In today’s world, the heirs get a stepped-up basis current market value. They could sell the day after inheritance and have no tax consequence. On the bright side, it allows assets to be conveyed from one generation to another.

And obviously you’re always triggering that estate tax situation, too. So you’ve got your tax people are going to be working with you. Your financial planners are going to be looking at your estate level… How much is in that? What’s going to be passed there, where you’re subject to estate taxes? But gifting things, we’re always in a situation where people are gifting some assets, and others are looking to just continue to defer until they pass away, and theirs get the stepped-up basis.

David Moore: As I said, this is on the chopping block. Hopefully it doesn’t go away. It’s an opportunity that’s here now. But use what you know you have. If we worry about all the things that could happen, we probably wouldn’t do anything. So I’m just going to tell you use these things while they’re there. If you’ve got a situation where you’re concerned about, you’ve got questions, don’t hesitate to reach out. Equity Advantage, 1031Exchange.com.

Once again, my name’s David Moore. And as we get more information, we’re going to be shooting a new video and tell you what it is. So if stepped-up basis goes away, then we will immediately get information out. Or if we have a situation where it looks like that’s going to be happening, we’re going to be getting that information out right away.

David Moore: Thanks for joining us today. David Moore, Equity Advantage, 1031Exchange.com. And I look forward to speaking with you soon. Take care. Bye bye.