A person asked me the other day to explain the step-up in basis rules. This can be very complicated so I will digest down to the very basic elements. Let’s say dad buys a house for $25,000 in 1966.  Let’s say that house is now worth $300,000.  If dad sells the house while he is alive he can likely qualify for the $250,000 exemption upon sale. That is, if he sells the house for $300,000 with a basis of $25,000 (let’s assume no adjustments to basis) he has a $275,000 gain on sale. However, he has the $250,000 exemption if he has lived in the personal residence for two of the last five years. That leaves only $25,000 subject to tax upon sale. Between federal and state capital gains tax you are probably talking 25-30% in California so $5k-$10k in tax to be paid.

The problem that some people create is they try to outsmart the law and avoid attorney fees. They come up with a master plan to avoid probate and avoid attorney fees. They will simply transfer the house from dad to son now, before death.  Ok, there is a $5,240,000 gift tax exemption so the transfer is without gift tax as the house is only worth $300,000. However, what happens when son sells?  Son receives dad’s basis of $25,000 and thus he is facing a $275,000 gain on sale. You can do the math… BIG TAX BILL!

The best answer, in most cases, is to let the house transfer from dad to kids at his death. By doing this the kids will receive a STEP-UP IN BASIS!  A step-up in basis happens when a property transfers at death. It gives the inheritors the decedent’s date of death value as their basis. Thus $300,000 is the new basis. If the property is then sold for $300,000 there is ZERO TAX upon sale!

-John