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Mastering Asset Depreciation in Step-Up Scenarios: Community vs. Separate Property States

Mastering Asset Depreciation in Step-Up Scenarios: Community vs. Separate Property States

April 15, 2024

As inflation rates persist at elevated levels, an increasing number of people turn to real estate investment and utilize it as a safeguard against inflation. For most individuals and households involved in real estate ventures, it serves not only as a financial asset but also as a lasting legacy to be inherited by future generations. Understanding how asset depreciation works within a step-up basis context empowers individuals to devise more efficient estate plans, enabling them to implement informed strategies to optimize tax advantages. 


When an individual inherits a property, whether through a will or as a beneficiary of a trust, the asset's value is reassessed to align with its fair market value (FMV) at the time of the original owner's death. This process is commonly referred to as a "stepped-up basis”.This means that if the property is sold later, the heirs or recipients only incur capital gains tax on the appreciation of the asset from the date of inheritance, rather than from its original purchase price. 


For depreciable assets involved in rental activities, regardless of whether they have reached the end of their useful life at the time of inheritance or transfer, the stepped-up basis resets the depreciation schedule for the property. The new stepped-up basis is then used for another cycle of depreciation going forward. Consequently, heirs or recipients are not liable for any depreciation recapture in this scenario. 


In the 9 states where community property laws apply, such as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin, assets obtained during marriage are typically regarded as jointly owned by both spouses. Consequently, both partners hold a stake in the asset, encompassing any increase or decrease in its value during the marriage. Hence, when one spouse passes away in a community property state, the surviving spouse is entitled to a 100% step-up in basis. 

For instance, in a community property state, a husband and wife own a shopping plaza, which was initially purchased for $4 million and has been depreciated by $2 million. After the husband's death, the fair market value (FMV) of the plaza is $6 million. Due to the step-up, the wife inherits the plaza at its FMV on the date of the husband's death. Consequently, the depreciation schedule is reset, and the plaza will depreciate based on a $6 million basis with a depreciable life of 39 years going forward. 


In states governed by separate property regulations, also known as non-community states, when it comes to a step-up scenario, assets inherited by one spouse may retain their status as separate property. When one spouse passes away, the surviving spouse may receive a step-up in basis for half of the property when their spouse dies.  

For instance, in a non-community property state, a husband and wife own a shopping plaza, which was initially purchased for $4 million and has been depreciated by $2 million. After the husband's death, the fair market value (FMV) of the plaza is $6 million. In this scenario, the asset would be divided into two portions: The wife may receive a step-up basis of $3 million for the husband’s portion, which is half of the FMV when the husband died, and she can use it as a basis to depreciate for another 39 years; As for the wife’s portion, it will retain the origin depreciation schedule and continue depreciating for the remaining life.  


In summary, taking advantage of the depreciation process within a step-up basis framework can prove to be a very powerful strategy. By resetting the depreciation schedule to the fair market value at the time of inheritance, individuals can potentially reduce their tax liabilities on capital gains when selling the property in future. 


Each individual's circumstances vary, and there is no universally applicable solution. For specific details, it is recommended to seek advice from a legal or tax professional to ensure accuracy and compliance with relevant laws and regulations.