How to calculate depreciation on inherited property
One of my favorite movies of all time, “Midway,” will undoubtedly be shown this Memorial Day weekend. The 1976 war movie has a tremendous cast of characters with Glenn Ford, Henry Fonda, Charlton Heston, Hal Holbrook, Cliff Robertson, Edward Albert Jr., and other stars telling the story of the June 4-7, 1942 battle of Midway Island. It was the largest battle ever fought exclusively between aircraft carriers and fighter planes.
Throughout history, there had been many maritime battles where the ships of one nation fought close-up with the ships of another power. This one was different in that the ships of neither power ever got close to each other. The aircraft of the United States Navy successfully sank four aircraft carriers of the Japanese Navy. We lost one carrier. Perhaps we got a bit lucky in that our planes found their ships before their planes found our ships. But we needed some good luck.
The Japanese had ruled the Pacific Ocean from December 7, 1941, as President Roosevelt famously said “a day that will live in infamy,” when the dastardly Japanese surprised and decimated our fleet at Pearl Harbor. That rule lasted a grand total of seven months.
This may be the greatest example of what goes around, comes around. It usually happens. It doesn’t usually happen in seven months. They got lucky when we were surprised by the sound of Japanese dive-bombers, torpedo planes, and fighters filling the skies over Pearl Harbor. We lost over 2,000 soldiers and sailors.
We got lucky at Midway a mere seven months later when our dive-bombers, torpedo planes, and fighters filled the skies over the Japanese carriers. They lost over 3,000 soldiers and sailors.
From this battle on, we ruled the Pacific Ocean and the Japanese steadily were beaten back and ultimately defeated. Granted, it took a few years, but it started at Midway.
I love this story because it illustrates American perseverance and courage. Being the underdog only made them fight harder.
We are fortunate today to live in a country that can celebrate these accomplishments. My heartfelt “Thanks” goes out to all of those who have served or are serving now in the military so that we can continue to celebrate holidays such as Memorial Day.
I went to tax conference in Frankenmuth last week that was very interesting. There were two topics that really hit the hot button, so to speak. We seem to be encountering these two every day.
The first was the topic of debt forgiveness when a bankruptcy and foreclosure occurs. When exactly do taxpayers owe tax when they are forgiven mortgage debt, credit card debt, automobile loan debt, etc?
The second subject was the topic of what happens to the basis of property when it is inherited? The particular emphasis was inheriting investment or rental property and how to calculate depreciation on that inherited property. I will discuss the inherited property this week and then take a look at the debt forgiveness next week.
Under our current set of tax rules, when a taxpayer dies, property owned by that person receives an adjustment that makes the tax basis of the property equal to the fair market value on the date of the taxpayer’s death, regardless of what the taxpayer paid for the property.
For example, Joe dies on January 31, 2012. He owned a rental in Rockford and a condo. He bought the rental back in 1955 for $25,000. It was his personal residence at the time. In 1980, he purchased the condo for $75,000. He moved into the condo and converted the old residence into rental property. Under the tax laws of 1980, Joe could depreciate the rental over 15 years so by 1995, the rental was totally depreciated or written off. When Joe died on January 31, he owned a fully depreciated rental and a condo that he paid $75,000 for. The fair market value of the rental on that date was $125,000 and the fair market value of the condo was $150,000. Joe had a trust set up by Neil Blakeslee, so the trust now owns both properties. Joe has two beneficiaries who want to keep the rental but sell the condo. They sell the condo for $150,000.
When Joe died, the trust received a step-up in tax basis to the fair market value of the condo on Joe’s date of death to $150,000. Even though Joe paid $75,000, the beneficiaries receive a benefit under the tax laws and are able to not pay any tax on the gain.
As far as the rental goes, the tax basis of the rental becomes $125,000. Depreciation is based on tax basis so the beneficiaries are able to begin depreciating the rental on that amount after deducting an amount for the value of the land. This is quite an advantage. Joe had already written off the entire cost of the rental and now his beneficiaries get to write off the rental’s full fair market value. They get to start over and depreciate an additional $125,000.
An important further point to make is this: If Joe was married at the time of his death, Joe’s wife would inherit one-half of the rental and she would qualify to begin depreciating Joe’s half of the rental. I’m convinced this scenario with a wife inheriting the deceased spouse’s half does get missed once in a while. It might pay for taxpayers inheriting property to talk to a tax professional to ensure these complicated tax rules are property applied. This is Jerry Coon signing off.
Jerry Coon is an Enrolled Agent. He owns Action Tax Service in Rockford on Northland Drive. Contact Jerry through his website at www.actiontaxservice.com.