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Writer's pictureKari Myers

What are the Important Differences of Carryover, Transferred and Stepped-Up in Basis?



Carryover Basis


Carryover Basis (CB) is often mistakenly referred to as Transferred Basis (TB).


The two are not the same, and the differences are very important to understand.


In general terms, when property is gifted from one person, called the donor, to another person, called the donee, the Basis that the donor has in the property is transferred to the donee, becoming the Transferred Basis.


But Carryover Basis is when there is a business transaction involving two pieces of property, one being sold and one being purchased, by a single investor, and the Basis of the sold property actually carries over into the Basis of the purchased property.


An example of this would be when you engage in a Section 1031 Like Kind Exchange.


Say you bought a duplex ten years ago for $200,000 and have operated it as an investment property. You have claimed $65,000 in Depreciation during that time.


Now you are selling the duplex for $400,000 and you are buying a replacement property of equal or greater value, engaging in a Section 1031 Like Kind Exchange in order to avoid paying taxes on the Capital Gains and the Depreciation Recapture.


You paid $200,000 for the duplex and you claimed $65,000 in Depreciation, which is deducted from the beginning Basis of $200,000, leaving you with a Basis of $135,000.


Under Section 1031, when you sell, you are allowed to take the $135,000 of Basis that you have not yet depreciated and that you have left in the Duplex, and carry it over into the Replacement Property, and continue to claim Depreciation on it, even though you no longer own it.


And this Basis is called Carryover Basis.


All in all, a pretty great deal.


Step-Up in Basis


*For Individual Taxpayers*


A Step-Up in Basis happens when the property owner dies, and the property is inherited either through the probate of a Will or the administration of an intestate estate, or the property goes into a trust.


Internal Revenue Code Section 1014, entitled "Basis Of Property Acquired From A Decedent," provides that the Basis of a Decedent's property will be changed (usually increased) to its Fair Market Value (FMV) as of the Date of Death (DOD).


The Step-Up in Basis will usually mean that the person inheriting the property can sell it without having to pay any Capital Gains Tax because the Sales Price will be the FMW, and the seller's Basis in the property is also the FMV, because that is what the Step-Up in Basis does, raise the Basis to the FMV.


The real benefit of the Stepped-Up Basis is when you use Section 1031 Exchanges for your entire lifetime to defer the Capital Gains taxes, and then pass your property to your heirs tax-free.


You might have started with an investment in a property with a Basis of $50,000 and, through a series of Section 1031 Exchanges, now you have property worth $1,000,000 but with a Basis of less than $100,000.


With a Capital Gains rate of 20%, the step-up in Basis will avoid a tax bill of about $180,000.


However, it is critical whether you are holding title to the property in your own name, or you own the property through a business entity.


You might still be entitled to claim a Stepped-Up Basis if you hold property thorough a business entity, but it will depend on the business entity in which you are holding the property.


FOR BUSINESS ENTITIES


If you are not holding real property in your own name, then Partnerships and LLCs are the best business entities to use.


The LLC can elect to be treated as either a disregarded entity, a partnership, or as an S Corp for tax purposes. But is should not be treated as a C Corp.


By taking an Internal Revenue Code Section 754 election upon the death of a shareholder, the Partnership or LLC gets a step-up in Basis for the property in the hands of the beneficiary.


For example, let's assume that yo and your brother set up a corporation and each of you put in $50,000 and each of you own 50% of the stock. The corporation buys a warehouse for $100,000.


Ten years later, you die and leave everything to your son, and the warehouse is worth $1,000,000.


Your son will receive a Stepped-up Basis in the value of the corporate stock.


But the corporation will not receive a Stepped-up Basis in the value of the warehouse. The warehouse is owned by the corporation, and the corporation did not die. If the warehouse is sold, the corporation will owe taxes on $900,000 of Capital Gains. (Including an undeterminable amount for Depreciation Recapture Tax). In effect, your son will pay half of the taxes because it will come out of his half of the corporations funds.


Now, let's assume that you and your brother set up an LLC instead of a corporation, and that everything else is the same. The LLC will be treated for tax purposes as a Partnership because there is more than one owner.


When you die, the LLC makes a Section 754 election, and the son's share of the LLC assets receives a Stepped-up Basis to $500,000.


If the LLC sells the warehouse, the son will have no Capital Gains taxes to pay. If the LLC does not sell the warehouse, the son has a Basis of $500,000 inside the LLC which he can depreciate.


Transferred Basis


If you receive a property as a gift, your Basis in the property will be the same as the Basis of the individual who gifted the property to you.


The Basis is "Transferred" to you and is called a Transferred Basis.


Internal Revenue Code Section 1015, entitled "Basis of Property Acquired By Gifts And Transfers In Trust," says "If the property was acquired by gift ... the basis shall be the same as it would in the hands of a donor or the last preceding owner by whom it was not acquired by gift..."


For example, a mistake often made by elderly parents regarding their real property is that they want to gift it to their children before they die so that it will not have to go through Probate, having heard horrible things about the Probate process.


Here's the problem with that:


The parents might have property worth $400,000 that they have owned all of their lives and in which they might have a very low Basis, or no Basis at all due to Depreciation taken.


If it is gifted to the children, when the children sell it, they will have a Capital Gains tax on the entire $400,000, possibly as high as 20%, because they have no Basis in the property, or very low Basis to deduct from the Sales Price because their Basis is the same as the Basis of the parents who gifted the property.


This is Transferred Basis.


Since the parents are probably living in the property as their residence, they could sell it and under Section 121, they would be able to exclude all of the Capital Gains from taxation.


Also, they could probably sell it at FMV to the children, and even do Owner Financing.


They could also continue living in the property and renting it from the children, with the monthly rent payments being equal to the monthly note payments.


There are many ways to handle passing property to heirs with little or no tax consequences, but it requires the expertise of someone who does that for a a living.




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