Tax Law Center Blog

Understanding the Step-Up in Basis

Under Internal Revenue Code Section 1014(a), the basis of inherited property is stepped up to its fair market value (FMV) at the time of the decedent’s death. This means that when the heir sells the asset, any appreciation before the decedent’s death escapes capital gains tax.

The “step-up in basis” is a crucial tax rule that can significantly benefit those inheriting assets. This adjustment can lead to substantial tax savings for heirs/recipients.  

Foreign Inherited Property and Step-Up Basis

Many U.S. taxpayers inherit foreign property from non-U.S. relatives or U.S. citizens residing abroad. Importantly, the step-up in basis under IRC § 1014 applies to all inherited property, regardless of location, as long as the heir is a U.S. taxpayer. This means that foreign real estate, foreign securities, or business interests can also receive a step-up in basis, reducing capital gains tax when the heir eventually sells the asset.  For example, see IRS Rev. Rul. 84-139.

Life Estates: Explicit and Implied Recognition

A life estate divides property ownership, granting one person (the life tenant) the right to use the property during their lifetime, with the remainder passing to another (the remainderman) upon their death. While typically created through formal legal documents (explicit), a life estate can also be recognized after death as “implied” based on the circumstances of the property transfer and the deceased’s actions. This often occurs when the deceased transferred (gifted) the title but continued to live in the property, paying expenses as if they still owned it.

Identifying an Implied Life Estate Post-Mortem

An implied life estate, not formally documented, can be inferred from the deceased’s conduct and the situation surrounding a property transfer. Key indicators include the deceased continuing to live in the property after transferring title, paying property taxes, insurance, and maintenance costs. This pattern suggests they retained a lifetime beneficial interest. Under Internal Revenue Code Section 2036(a), the IRS may likely recognize this if the deceased retained possession or enjoyment of the property for life.  

The Post-Mortem Link: Implied Life Estate and Step-Up in Basis

If an implied life estate is recognized after death, the property is typically included in the deceased life tenant’s gross estate for federal estate tax purposes. This inclusion is vital because it allows the remainderman to receive the property with a “stepped-up” basis to its fair market value on the date of death. This can significantly reduce capital gains taxes if the heir later sells the property.  

Case Example: Estate of Lindner v. Commissioner

The case of Estate of Lindner v. Commissioner, 85 T.C. 161 (1985), illustrates this concept. In this case, a father transferred his farm to his sons but continued to live on and manage it, receiving the income until his death. The Tax Court determined that an implied agreement existed, resulting in the farm being included in the father’s estate. This allowed the sons to receive a stepped-up basis in the property. The court focused on the father’s continued occupancy, management, and income as evidence of a retained lifetime interest, even without a formal retained life estate.  The court’s principles continue to be applicable in similar estate matters today.

Post-Mortem Considerations and the Importance of a Tax Opinion Letter

When faced with a situation where a deceased individual transferred property but continued to function as the owner, the possibility of an implied life estate should be thoroughly explored. If recognized, this can provide significant tax benefits through the step-up in basis. However, establishing an implied life estate after someone has passed away can be complex.

To navigate this post-mortem reactive planning, obtaining a formal tax legal opinion letter is highly recommended. This opinion letter, prepared by a qualified tax attorney, will analyze the specific circumstances surrounding the property transfer and the deceased’s actions. It will provide a reasoned opinion on the likelihood that the IRS will recognize an implied life estate, thus allowing for the step-up basis. This strengthens your position with the IRS, and can be invaluable in providing clarity and potentially mitigating tax liabilities and penalties for the heirs.