Whenever a person sells an asset, whether personal or real, the person needs to determine cost basis of the item to ascertain whether or not the sale results in a taxable gain. For example, John purchases 118 Green Street in CA for $100,000 in 1985. The cost basis would be $100,000. If, generally speaking, John ever sold the property for greater than $100,000 such sale would result in a taxable gain.
One of the prime benefits of acquiring real property through inheritance is the application of "stepped-up basis." The result of stepped-up basis is that a person who inherits real property receives a new cost basis which is pegged to the fair market value of the asset at the date of the decedent's death. IRC §1014(a); Rev & T C §18031. Yes, that is how it is written in tax terminology. For example, from above, John purchases 118 Green Street for $100,000 in 1985. Due to real estate appreciation (just go with it), John's home gradually increases in price to $700,000 in 2012. John then dies in a tragic hot air balloon accident in 2012 in Morgan Hill, CA. John's heirs would be entitled to claim $700,000 as the cost basis of the home. Subsequently, when John's heirs sell the home, the starting point for a taxable gain would be $700,000, whereas the starting point for John would be $100,000. Though capital gains tax is much lower than regular income tax (see Mitt Romney tax return for 2010), it still is roughly 25% combined for federal and state, that is California. When you multiply that by 600,000, the result is a rather large number. Thus, it is quite clear that stepped-up basis affords heirs an enormous tax savings because they are not liable for the appreciation that has accumulated over the years. Rather, the heirs can take advantage of the new date of death value of the asset. The common result is that heirs of real property often pay little to nothing in capital gains taxes if they sell the inherited property shortly after receiving it.
