Inheriting real estate can be a significant financial windfall for beneficiaries. Depending on how it’s received, though, inherited real property can come with some important financial considerations.
Passing inherited real estate along to your heirs upon your death rather than gifting it to them while you are still alive has significant tax benefits, especially if the assets were part of a 1031 exchange. In a 1031 exchange, owners of investment properties are allowed to fully defer any accumulated capital gains taxes provided they roll sale proceeds over into like-kind replacement properties. When the assets are transferred to an heir, the beneficiary receives the property at a stepped-up basis that can eliminate these deferred gains.
The step-up in basis also eliminates any downward basis adjustments that were claimed during the holding period of the asset, including amortization and depreciation. Below we’ll go into greater detail on depreciation recapture and how it’s treated on inherited assets.
How Does Depreciation Recapture Work?
Depreciation of a physical asset, such as an investment property, lowers the amount of ordinary income you’ll have to report to the IRS in a given tax year. It also reduces your cost basis in the asset. However, if you end up selling the asset and realize a profit, you will be taxed at your nominal tax rate for the full amount of any previous depreciation deductions claimed on the property. This process is called depreciation recapture.
If you complete a straight sale, any downward adjustments in basis, such as depreciation claimed on appreciating assets, are charged back upon divestiture. The IRS gave you a tax break on your ordinary income while you held the asset, but if you sell the property for a profit, the IRS wants that money back. Since the depreciation you claimed helped offset your ordinary income, you’ll be taxed at your nominal tax rate when you file taxes for the year in which the asset was sold. However, if you complete a 1031 exchange, you are allowed to defer any realized capital gains and depreciation taxes that would normally be due.
Do You Have to Pay Depreciation and Capital Gains Taxes on Inherited Property
Passing real estate to your heirs after you die rather than while you are still alive has significant tax advantages, especially for 1031 exchange investors.
As noted, investors who complete 1031 exchanges can defer capital gains taxes on appreciated assets. They also can claim depreciation on their replacement assets, which lowers their cost basis in the property. Heirs who receive bequeathed property receive it a stepped-up value, which is the current fair market price of the property. For highly appreciated assets, this step-up may fully erase any accumulated capital gains.
It also wipes out any previously claimed depreciation adjustments to the cost basis in the property that were enjoyed by the previous owner. The heirs can begin claiming depreciation on the asset, which will reduce their ordinary income and lower their cost basis in the property.
Putting it all Together
Depreciation is an important tax benefit for owners of commercial and residential investment properties. Commercial assets can be depreciated over a 39-year period, while residential properties can be depreciated over a 27.5-year period using the straight-line method for both.
Investors who sell real property will have to pay back any depreciation claimed on an asset unless they complete a 1031 exchange. If you bequeath your real property holdings to your heirs, they receive those assets at a stepped-up basis to fair market value that can erase any deferred capital gains tax liabilities, as well as wipe out any depreciation claimed over time you held the property. They also can begin depreciating the asset themselves over the full useful life of the asset.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
