How to Report Step-Up Basis on Rental Property

When someone inherits a rental property, the IRS allows for a step-up in basis, adjusting the property’s value to its fair market price at the time of inheritance. This affects capital gains taxes when the property is sold and depreciation calculations for rental income. Properly reporting this adjustment ensures compliance with tax regulations and may help reduce future tax liabilities.

Identifying Assets Subject to a Step-Up

Not all assets qualify for a step-up in basis upon inheritance. Rental properties held individually or in a revocable living trust typically receive this adjustment, while those owned by irrevocable trusts or business entities may not. The key factor is ownership structure and how the asset transfers upon death.

For properties held in joint tenancy with rights of survivorship or as community property, step-up treatment varies. In community property states such as California and Texas, both halves of the property receive a full step-up. In common law states, only the deceased owner’s portion is adjusted, affecting future capital gains calculations when the property is sold.

Liabilities like mortgages or liens do not impact the step-up basis but can influence estate tax calculations. If the property was under an installment sale agreement or leasehold interest, additional tax considerations may apply. The IRS also differentiates between real estate used for rental purposes and personal-use property, which affects depreciation eligibility after the step-up is applied.

Calculating the Fair Market Value

Determining the fair market value (FMV) of an inherited rental property requires an accurate assessment of what a willing buyer would pay at the time of the previous owner’s death. The IRS accepts valuations based on independent appraisals, comparable sales, or professional opinions from certified real estate professionals. The method should reflect current market conditions, property condition, and income-generating potential.

A professional appraisal is typically the most reliable approach, especially for estate tax filings. Certified appraisers evaluate recent sales of similar properties, local demand, and unique attributes that may affect value. If an appraisal was conducted for estate tax purposes, that valuation is generally used as the FMV. If no formal appraisal was obtained, alternative methods such as a comparative market analysis (CMA) from a real estate agent or multiple broker price opinions (BPOs) may be considered, though these may carry less weight in an IRS audit.

For rental properties with active lease agreements, FMV should reflect both the property’s physical attributes and its income potential. Capitalization rates, which measure expected returns based on rental income, can help estimate value. For example, if a property generates $24,000 in annual rental income and similar properties in the area have an 8% capitalization rate, the implied FMV would be $300,000 ($24,000 ÷ 0.08). This method is particularly useful for multi-unit buildings or commercial rentals where income generation is a primary valuation factor.

Market fluctuations between the date of death and the valuation date can affect FMV calculations. If property values have changed significantly, referencing multiple valuation methods can help establish a reasonable range. Estates exceeding the federal exemption threshold ($13.61 million for 2024) may use the alternate valuation date under IRC 2032, which allows valuation six months after the date of death if it results in a lower estate tax liability.

Incorporating Depreciation and Adjustments

Once FMV is established, depreciation must be factored into the property’s adjusted basis. Rental properties are considered income-producing assets, and the IRS requires owners to depreciate their value over time. Residential rental properties follow the Modified Accelerated Cost Recovery System (MACRS) with a 27.5-year straight-line depreciation schedule, while commercial rental properties are depreciated over 39 years.

To calculate depreciation, the land value must be excluded, as only the building and eligible improvements qualify. If an inherited property is valued at $400,000 and the land portion is determined to be $80,000, the depreciable basis would be $320,000. Using the straight-line method, the annual depreciation deduction would be approximately $11,636 ($320,000 ÷ 27.5).

Capital improvements made after inheritance must be added to the property’s basis and depreciated separately. Structural renovations such as roof replacements or HVAC system upgrades follow their respective recovery periods. Land improvements, such as driveways or landscaping, typically follow a 15-year depreciation schedule under MACRS. Properly tracking these adjustments ensures accurate tax filings and prevents underreporting of allowable deductions.

Reporting on Applicable Tax Filings

An inherited rental property must be properly documented in tax filings to reflect the step-up in basis and subsequent financial activity. IRS Form 1040, Schedule E, is used to report rental income and expenses, while Form 4562 initiates depreciation deductions based on the adjusted basis.

If the property is sold, capital gains or losses must be reported on Form 8949 and summarized on Schedule D. The step-up in basis significantly affects taxable gain, as only the difference between the adjusted basis and sale price is subject to capital gains tax. Any depreciation claimed post-inheritance is subject to recapture under Section 1250, which imposes a 25% tax rate on the portion of gains attributable to prior depreciation deductions. This often results in a blended tax liability, combining ordinary income treatment for depreciation recapture with capital gains rates for the remainder of the appreciation.

Recordkeeping Requirements

Maintaining thorough documentation is necessary for substantiating the step-up in basis, depreciation deductions, and future capital gains calculations. The IRS requires taxpayers to retain records supporting the valuation, acquisition date, and any adjustments made to the property’s basis.

Key documents include the appraisal or valuation report used to determine FMV at the time of inheritance, estate tax filings if applicable, and legal documents proving ownership transfer. Additionally, depreciation schedules, receipts for capital improvements, and records of rental income and expenses should be kept for at least three years after filing the tax return on which they were reported. If the property is sold, records related to the original step-up in basis and subsequent adjustments should be retained indefinitely to support capital gains calculations.

Evaluating Gains or Losses

When an inherited rental property is sold, the step-up in basis determines taxable gains or losses. The difference between the sale price and the adjusted basis, which includes the step-up and any capital improvements, dictates the tax implications.

If the property sells for more than the adjusted basis, the gain is subject to capital gains tax, with long-term rates of 0%, 15%, or 20% depending on the taxpayer’s income bracket. Depreciation recapture under Section 1250 applies to the portion of the gain attributable to prior depreciation deductions, taxed at a flat 25% rate. If the property sells for less than the adjusted basis, a capital loss may be recognized, which can offset other capital gains or up to $3,000 of ordinary income annually. Properly evaluating these factors ensures accurate tax reporting and helps in planning for potential liabilities.