Cost basis step-up on inheritance of real estate

Question

Assume there is a property owned by a couple with one son. When one parent dies, s/he bequeaths one half interest in the property to the son and half to the spouse.

Two years later the property is placed in service as a rental and both surviving parent and son start taking depreciation on their tax returns.

The other spouse dies 10 years later, at which point the market value has increased dramatically. The son inherits the remaining half.

My question is how to calculate the son's basis in the property. To make things a little easier, let's use some concrete numbers:

                                    Entire     Son's
                                  Property     Share
                                  --------  --------
FMV when first parent dies        $400,000  $200,000
FMV when second parent dies     $2,000,000
Son's accumulated depreciation              $ 20,000

Based on my research, the son's basis is

$200,000 - $20,000 + $1,000,000 = $1,180,000

I.e. the cost basis of his half at inheritance, minus accumulated depreciation, plus the stepped up basis of the second parent's half at death.

Is this correct?

Answer 1

You are on the right track. As this seems more an accounting question than an actual tax question, I'll point out several points of discussion.

Assume there is a property owned by a couple with one son. When one parent dies, s/he bequeaths one half interest in the property to the son and half to the spouse

And

Both parents owned the property as joint tenants. This is in the US, with regards to federal tax only

So, unless there is an existing agreement to state otherwise, the not-dead spouse already owned half the property. So, per your example, the son's share would be .5 of 200,000, as the mother already owned half, and received half.

So your updated table would be

                                Entire     Son's
                              Property     Share
                              --------    --------

FMV when first parent dies    $400,000    $100,000 
FMV when second parent dies   $2,000,000  $500,000
Accumulated depreciation      $40,000     $10,000

At this point, the jurisdiction issue really hits your problem.

To quote my old prof, what is this depreciation that we speak of? You mention that they deduct this depreciation on their tax returns, but you do not mention a tax basis for the property (which would matter for the mother's interest). The son took the property at FMV, presumably, but not for sure (as mentioned, rules vary).

In any case, to your actual question, no your basis is not correct. Assuming that we take the property out at FMV (ignoring estate exclusion, ect) the correct basis after dead momma/poppa2 would be

$100,000 - $10,000 + ($1,900,000 - taxbasis) = $1,990,000