The "basis" of your home is the value of your home for tax purposes. Your original cost basis is the amount of money that you paid for your home. As time goes by, events adjust this cost basis in either direction. Examples include appreciation or depreciation, improvements to your home, or damages that cause a drop in value.
The effect on your annual property taxes is straightforward. Over time, your property is reassessed, and your annual property taxes will be adjusted based on the revised value of your home. However, when it comes time to sell your home, your capital gain or loss from the home is considered as one change upon sale. It is the same principle as buying a stock and holding onto it for many years before selling it.
Basis forms the reference point for gain or loss, and thus the amount of tax involved with the sale. Understanding the concept of step-up basis and when it applies can help you avoid a significant tax hit upon sale.
Assuming the simple case with only appreciation changes, your capital gain on your home sale is the difference between the sale price and what you originally paid for the home. If you have been in your home for many years, that capital gain may be substantial and subject to a hefty tax.
Good news: In most cases, you can exempt up to $250,000 in capital gains ($500,000 for couples) as long as the home was your principal residence for two of the five years before your sale. This covers many straightforward home sales.
Bad news: This does not cover some situations such as investment properties, second homes, cases where a home or a partial interest in a home has been gifted to you, joint ownership with children, or inheritance of the home.
More good news: In the case of inheritance, you are able to claim a "step-up in home basis", meaning that your basis in the asset is updated to the current market value of the home. The capital gains on the eventual sale are calculated using your stepped-up value as opposed to the original basis, which could save thousands of dollars in taxes.
Inheritance and estate taxes may apply depending on the value of the home and where you live. However, in the majority of cases, the capital gains tax you would pay upon sale without the step-up is far greater than the combined estate and inheritance taxes.
More bad news: Many people do not realize how the step-up in basis works, and incorrectly gift their home to their heirs or change the ownership to joint ownership with their heirs assuming that they are saving estate and inheritance taxes. This leaves heirs with a large tax burden upon an eventual sale.
There are cases where the step-up in basis is not straightforward, such as cases where a spouse passes away, and the home is held in joint tenancy with right of survivorship. This case results in a half-step-up in basis, based on the 50 percent of the home that the deceased spouse held.
As a general rule, you need to consider the step-up in home basis when considering the disposition of your home, especially if your home has greatly appreciated (or depreciated) over time. However, it is always best to consult with a professional to verify how the step-up in basis would work in your situation, and how to construct your estate plan to make sure that all of your wishes are met.