It’s not uncommon for a family to have questions about the taxes on a property that is inherited at the death of a surviving spouse. This involves the property’s cost basis, which can be a bit confusing.
There are a couple of issues to understand in this scenario, says NJ.com in “Figuring cost basis for an inherited home.” When an appreciated asset is inherited, the person who inherits the asset gets a step-up in basis. This means the appreciation in the property that took place during the deceased person's lifetime, isn’t attributed to the person inheriting the asset.
If we assume that a husband and wife owned real property that appreciated in value, the surviving spouse would receive a step-up in basis at the death of the first spouse on the one-half interest of that deceased spouse.
When the second spouse dies, the children who have inherited the property also get a step-up in basis for the entire property equal to the fair market value (FMV) of the property, as of the date of the death of the second spouse.
Here’s a quick illustration:
A husband and wife purchased real property for $400,000. They don’t make any improvements to the home. When the husband passes away, the fair market value of the property is $500,000. That’s an appreciation of $100,000. The wife receives a step-in basis of the husband's 50% interest in the property. That interest is now valued at $250,000. In addition, the wife also retains her cost basis in the property ($200,000, or one half of the $400,000 purchase price) for a total cost basis of $450,000. That would be her cost basis, if she sold the property during her lifetime.
However, if the wife as the surviving spouse retains the property at the time of her death (and the property is still worth $500,000), then the children who inherit it would receive a step-up in basis of $500,000. So, if we say that the property is worth $600,000 at the time of the wife's death, the children's step-up in basis would be $600,000.
An experienced estate planning attorney will be able to help you find the best way to pass the family home onto the next generation, if that is your wish, or to help your heirs navigate the calculations and any tax liabilities, if they inherit the family home.
Reference: NJ.com (July 6, 2017) “Figuring cost basis for an inherited home”