I seem to get an email on at least a monthly basis asking what "my cost basis is" when the person inherits property, usually farm land. The email usually goes into great detail about the cost basis of the property when it was originally acquired by their parents or grandparents and usually has very little detail about the value of the property when the person passed away. Here are the general rules on cost basis for inherited property:
- First, when property is inherited and passes through an estate, the original cost does not matter. The new cost basis will be equal to fair market value of the property at the time of death (or 9 months later in some rare cases). As an example, assume Farmer John owns 500 acres of farmland that he purchased in 1960 for $50,000. In 2015, he passes away when the value of the farmland is $5 million. His grandson Jim inherits the property and decides to sell it for $5.2 million. His cost basis is $5 million and he will have a $200,000 long-term capital gain even if he sells it less than a year after inheriting the property (Capital gain property inherited is automatically long-term).
- If the property is jointly owned, it gets trickier. In most cases, the property is treated as being half-owned by each (this can be different, but that is a much longer subject). Therefore, if Farmer John was married to Mary, and if Mary inherited the property, her cost basis is now equal to her basis of $25,000 (on half) plus $2.5 million for a total of $2,525,000. This is the rule for separate property states.
- If you live in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin), then a special rule applies that allows for a step-up in basis for both halves. In our example, Mary would be allowed to have a cost basis of $5 million if she lived in one of these states. If you live in a separate property state and you time it right, move to a community property state to take advantage of this if you plan on selling a major asset.
Now, let's assume that Farmer John gifted his farmland to Jim before he passed away. In this case, the cost basis would now be equal to the original cost of $50,000. Property that is gifted has a cost basis equal to the lower of cost or fair market value.
This is the major reason why we want to have assets pass through an estate if there is no estate tax owed.