When someone receives a gift, the recipient of the gift is not responsible for reporting the value of any gifts as income. Rather, it is the gift-giver, or donor of the property, who is required to pay gift taxes if the value of the gift exceeds the annual gift tax exclusion.
Taxes become an issue for the gift’s recipients when they sell the gifted property. The gift’s recipient is deemed to have owned the property for as long as the donor owned it, and also takes the donor’s cost basis (the original value of the property). This is true for gifts made while the donor is alive.
Different rules apply to inherited property. When the transfer occurs after the donor’s death, the recipient of the property receives a step-up in basis to property’s date-of-death value. This can result in significant tax savings when the recipient sells the property.
Taking the example above, suppose that instead of giving you the property during her life, your mother holds on to the property, which passes to you when your mother dies. In this situation, your cost basis would be the value of the property on the date of your mother’s death. If you sell the property right away, you will not have have to pay any capital gains taxes.
Property that is transferred by transfer on death deed in Texas occurs at the donor’s death. Therefore, the beneficiary of such property should get a step-up in basis on the property just as if it had passed through probate. The benefit of having a transfer on death deed is that the property would pass by operation of law, bypassing the costs and time associated with a probate proceeding.
An Example With Numbers
Suppose your mother bought property for $30,000 that is now worth $100,000. If she gives it to you during her life, you take her $30,000 basis. Sell it for $100,000 and you report a $70,000 capital gain, although you get long-term treatment because you are treated as having owned it as long as she did. If instead you inherit the property at her death, your basis steps up to $100,000. Sell it right away for that amount and there is no capital gain. Sell it later for $125,000 and the gain is $25,000.
I once had a client whose elderly mother owned real estate she had bought decades earlier for very little and that had appreciated more than a hundredfold. Whether that property passed by gift or at death made an enormous difference in the tax her children would eventually owe.
Is the Step-Up Still in Place?
Yes. Proposals to eliminate the step-up in basis have been discussed several times, but the Tax Cuts and Jobs Act of 2017 kept it, and it remains part of the tax code. Because the rules can change, plans that depend on it should be reviewed when tax legislation passes.
A Texas Advantage: The Double Step-Up for Community Property
Texas is a community property state, which brings a valuable tax rule. When a married person dies, not only the deceased spouse’s half of community property but the surviving spouse’s half as well generally receives a new basis equal to its value at the first death. A couple who bought a home together decades ago may therefore wipe out the built-in gain on the entire property at the first death, not just half of it. Separate property, and property in non-community-property states such as North Carolina, does not get this treatment.
Other Transfers at Death
The same step-up generally applies to property passing under a will, through intestacy, by a revocable trust, or by a lady bird deed, because in each case the property is included in the owner’s estate at death. That is one reason deeding a home to children during life is often a costly mistake. See should I deed my home to my kids before I die?
