Owning Land

Stepped-up basis for heirs

When you buy land, you need to establish your “basis” for tax purposes. Starting basis is basically your purchase price, plus, perhaps, certain expenses that you incurred.

When you buy real estate, you will often need to allocate basis at the time of purchase among several different accounts, such as improvements (house, barns), timber (separate merchantable timber with immediate sale value from pre-merchantable with future value), minerals and land. The total of these basis accounts cannot exceed your overall basis in the property. Individual basis accounts are set up at the time of purchase, because a landowner often does different things in each account, which increase or decrease the individual account’s basis. As you hold the property, each basis account will be adjusted according to what you do. If you build a bridge, the basis in your land account increases, because it is a permanent improvement in the property. If you sell an acre from your land account, your basis will be reduced. Separate basis accounts can help you pay off a purchase through the sale of some assets.

All this jiggering of basis accounts is important to a landowner for tax purposes. Adjusted gross basis is the figure used in determining your tax liability when you sell or when the property is inherited. Each basis account will have its own adjusted gross basis at any particular point in time.  Sale of a house from a land acquisition, for example, just after you purchase the property will in all likelihood use up all the basis in your house-basis account.  The amount of tax you owe on the sale of a particular asset is determined by the amount of taxable gain you have. Taxable gain is the difference between your net selling price and your adjusted gross basis in the house. If you sell the house you just bought for what you just paid for it, you will have no taxable gain in the house basis account, hence no income tax on that sale. If you sell the house for more than what you just paid, you calculate your taxable gain, then pay your ordinary income rate on the gain. If you use up all the basis in your house account, your overall adjusted basis in the property as a whole decreases.

People who inherit property get, for tax purposes, a basis that is stepped up to its current market value, not the original basis. If they got the original basis, they would usually have a very large taxable gain when they — the heirs — sold the asset. With a stepped-up basis, taxable gain is figured on the adjusted basis at the time of death and inheritance. This increases basis and decreases taxable gain upon sale.

Steve Metcalf of Metcalf Land told me about a situation where the wife and kids of a deceased husband needed money that was locked up in appreciated land value. They want to sell some of the land to finance assisted care.  The widow’s adjusted basis in the land is about $1,000/A and the land’s current value is about $15,000/A.  This would produce a taxable gain of about $14,000/A. Taxed at a capital-gains rate of 15%, these circumstances would produce a tax hit of $2,100 on every acre.

If tax policy were changed to allow for the widow to transfer the land to be sold to her kids before she dies at the stepped-up value, they could sell it and avoid the big tax hit. As it is, they can’t afford to finance her care without the sale of the land, and the sale of the land by the widow will significantly reduce the amount of income available for her care.

So what is wrong with changing the tax code to allow for stepped up basis to heirs prior to the death of the Mom? The heirs, after all,  will get the stepped up basis when she dies.

Those who want to keep up with federal tax policy might start with Mark A. Segal’s, Real Estate Practitioner’s Tax Guide, current edition, from Knowles.

Are there any ways available for the family to sell some of the land for Mom’s long-term care and avoid the tax hit? What are your thoughts?

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About the author

Curtis Seltzer

Curtis Seltzer is a land consultant, columnist and author of How To Be a DIRT-SMART Buyer of Country Property and Land Matters: The “Country Real Estate” Columns, 2007-2009.

1 Comment

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  • One way: Don’t sell before she dies. Work with your banker and borrow (conservatively) against the fair market value of the land. Use the proceeds to care for the widow. When she passes, sell the land tax free and pay off the mortgage.

    Another way: Sell on a “Contract for Deed”. You recognize a part of the income each year but it is offset by medical & nursing home expenses.

    A good CPA (or an excellent attorney) can help minimize the tax bite of this situation.

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