This blog will focus on real estate assets to include your home, a second home, or rental property. I won’t go into selling property or the complex tax rules behind it. Instead, I’ll focus on what happens when you pass property on to your heirs while maximizing what you and your heirs get out of your property investments.  

Stepped-up Basis

If you or your spouse still own real property when the last of you passes away, all of your assets (including real property) that don’t automatically and immediately convey to a beneficiary will go through probate court. I will talk about a way to avoid probate with your real property later. Probate or not, taxes apply to the value of your property when it is sold minus the basis. The basis is typically what you paid for the property, but in the case of inherited real property the basis will be ‘stepped up’ to the current market value when it is inherited.

As an example, when my brothers and I inherited our parents’ house, we decided to sell it.   I was the executor (lucky me), so I asked our lawyer how we might determine the fair market value of the house to use as the basis. He looked at me and asked in a deadpan voice (paraphrasing here), “You’re selling it – right? [Yes] It’s the amount somebody is willing to pay for it. [Oh]” We sold the house shortly after inheriting it and used the selling price as the tax basis. It’s worth repeating that the tax you owe on a capital gain is based on the selling price minus the basis. To summarize the effect of the basis on an owner’s tax consequences, high basis = GOOD, low basis = BAD. Since the two were the same number in this case involving my parent’s house, we didn’t owe any tax on the sale. In fact we were able to deduct qualified closing costs (split 3 ways, of course).

This example assumes the heirs decide to sell the property to determine its value. If your heirs keep the property instead of selling, I suggest they get an appraisal soon after inheriting to set its stepped-up basis.

Depreciating an Investment Property

Now we will look specifically at investment property. This could be simply land or come with a rental house, but it is property not dedicated to your personal use. Be sure to ask your tax professional if you aren’t sure if you can depreciate a property. I will assume here that the property includes a rental house.

As with all investments, there are advantages and disadvantages associated with an investment property. Included in the downsides: loans usually require a 20–30% down payment and typically lenders require a higher interest rate if you don’t plan to live in the house. Again, personal experience here.

One of the upsides of buying a house on an investment property is depreciation – the reduction of your investment house’s value over time due to wear and tear. You can’t depreciate the land – no wear and tear. You lower your basis on the house yearly by the depreciation amount, but you can take a tax deduction against your normal income each year by the same amount. This will usually save you money on total taxes. You can get your depreciation amount from your accountant or tax software. It’s the same amount each year, so you only need to determine it once.

You might think that decreasing the basis and taking the same amount as a deduction each year sounds like a wash. Not quite. The amount you decease the basis increases the value of the house subject to capital gains taxes, while the amount of tax savings you get by using the deduction applies to income at your highest tax rate. Since the capital gains tax rate is probably lower than your highest tax rate, you probably save on your total tax liability by depreciating and taking the deduction.

Note that you are not required to depreciate your rental house, and at first I was hesitant to take depreciation on my rental house. But the IRS will assume that you took depreciation when you sell your rental house, so you might as well take it and get the benefits. All things considered, it appears to be advantageous to depreciate your rental house. Be sure to double check your unique situation with your tax accountant before making a final decision on depreciation. In case you are wondering, you cannot depreciate the residence you live in, or any other property dedicated for your personal use.

Combining Stepped-up Basis with Depreciation – An Idea

You may have detected an interesting possibility while reading this part on depreciation.

Let’s assume you buy a rental house property as an investment, but with the intent of keeping the property until your heirs inherit it. You depreciate the rental house as described above, getting the advantage of deducting the depreciation from your income over the next 27.5 years (the rule as of this writing). By the way, you can also deduct your expenses on the rental property like maintenance, interest on the loan, property taxes, insurance, you know – your expenses on the rental.

Over time, you could depreciate your rental all the way to a ‘zero basis.’ When your heirs inherit it, the basis resets to market value of the house—so they avoid taxes if they sell right away. Meanwhile, you’ve benefited from 27.5 years of deducting the depreciation. Even if they don’t sell immediately, their basis on the property is still the appraised value after it is inherited, (way above the zero, fully depreciated value it was for you). Your heirs would have avoided a lot in capital gains taxes on your estate – a very good thing. And you would have reaped a nice tax benefit along the way. Just a thought.

Transfer on Death Deed

Another item that falls under inheriting real property is the Transfer on Death (TOD) Deed which may also be called a Quit Claim Deed. Over half the states allow a Transfer on Death (TOD) Deed, which allows property to pass directly to heirs without probate.

Since there is no probate for the property, no other person can intervene to attempt to dilute the ownership of the property against your original wishes. If the TOD Deed is properly filed, the TOD beneficiaries own the property as of the date the last of you or your spouse passes away, well before the probate court is convened.

In my family, my brothers and I were listed on a TOD Deed for our parents’ house. It transferred to us immediately after our father passed.  If there is more than one owner on the TOD Deed all co-owners (and in Michigan, including their spouses) have to agree on the sale of the property. This turned out to be a non-issue for us, since we all agreed to sell the house immediately and we all agreed on a selling price.  A TOD Deed can save time and legal costs, but since it actually modifies the deed filed with the local government, I would highly suggest you consider getting the help of an attorney to set up a TOD Deed.