Why tax basis matters when transferring real estate
When you transfer a home, rental property, or other real estate to a family member, the tax basis determines how much taxable gain the recipient will recognize if they later sell. In short: lower basis → larger capital gain → more tax. Basis rules vary depending on whether the transfer is a gift, sale, or an inheritance, and choosing the right vehicle can change the outcome materially.
My work as a financial planner and estate adviser has convinced me that many families leave tens or hundreds of thousands of dollars on the table by treating ownership transfers as a paperwork task rather than a tax strategy. Below I walk through the practical strategies I use most often, the trade‑offs, and the paperwork and timing that matter.
Sources and legal background: the IRS publishes rules on basis and estate/gift taxes—see IRS Publication 551 on Basis of Assets and the IRS Estate & Gift Taxes overview for current rules and filing requirements (irs.gov/publications/p551 and irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes). These pages are the primary authority for federal basis and gift/estate tax rules; state rules can differ.
How basis is assigned: gift vs inheritance vs sale
- Gift: When property is transferred during the donor’s lifetime as a gift, the recipient generally takes the donor’s adjusted basis (carry‑over basis). The donee’s holding period includes the donor’s holding period for capital gains purposes. (See IRS Pub 551.)
- Inheritance: Property received from a decedent typically receives a step‑up (or step‑down) in basis to the fair market value at the date of death (or alternate valuation date), which often eliminates capital gains that accrued during the decedent’s lifetime.
- Sale at fair market value: Selling at FMV to a family member produces a purchase basis in the buyer equal to the price paid; this can be useful when the buyer has cash and the seller wants to realize value while minimizing future capital gains for the buyer.
Key nuance: If the donor pays gift tax on a gift, the recipient’s basis may be increased by the portion of the gift tax attributable to the net appreciation in the gift (see IRC §1015(b) and related guidance). That technical rule is worth discussing with your CPA if a sizable gift triggers gift tax.
Common tax‑basis strategies and when I use them
Below are the strategies I most often recommend, with practical pros, cons, and the typical scenarios where they make sense.
1) Hold until death (use the step‑up in basis)
- What it does: If you keep the property until you die, heirs usually receive a stepped‑up basis to the property’s fair market value at the date of death.
- Best for: Highly appreciated personal residences or low‑income heirs who might sell immediately after inheritance.
- Tradeoffs: Estate tax exposure (if your taxable estate exceeds federal and state exemptions) and loss of lifetime gifting flexibility.
2) Gifting during life (carry‑over basis)
- What it does: Gifting moves the donor’s basis to the recipient. The recipient carries the donor’s basis forward.
- Best for: Owners who want to reduce the size of their taxable estate or give early for non‑tax reasons (e.g., to allow a child to live in or manage the property).
- Tradeoffs: Recipient may face large capital gains if they later sell; donor may need to file Form 709 (gift tax return) if exclusions/exemptions are exceeded.
3) Partial gifting (annual exclusion + fractional shares)
- What it does: Transfer fractional interests across years using the annual gift tax exclusion to move value out of an estate without using lifetime exemption.
- Best for: Families seeking gradual wealth transfer while minimizing gift tax filings.
- Tradeoffs: Complexity in co‑ownership and future liquidity when multiple owners share title; carry‑over basis applies to gifted fractions.
4) Life estate (retain right to use property)
- What it does: Owner conveys remainder interest to heirs but keeps use (life estate) during their lifetime; heirs get remainder interest with potential step‑up at death depending on valuation and state rules.
- Best for: Owners who want to remain in the home while removing some value from their taxable estate.
- Tradeoffs: Irreversibility, Medicaid implications for long‑term care planning, and potential gift tax considerations. See our in‑depth guide on granting a life estate for pros, cons and procedural steps: “granting a life estate” (https://finhelp.io/glossary/granting-a-life-estate-pros-cons-and-tax-effects/).
5) Irrevocable trusts and grantor trusts
- What it does: Moving property into an irrevocable trust removes it from your taxable estate and can shift future appreciation out of your estate.
- Best for: High‑net‑worth families, owners concerned about estate taxes or creditor protection.
- Tradeoffs: Loss of control; funding must be done correctly. Grantor retained annuity trusts (GRATs) are useful when the grantor expects large future appreciation.
- Related reading: “Using grantor trusts to shift future appreciation out of your estate” (https://finhelp.io/glossary/using-grantor-trusts-to-shift-future-appreciation-out-of-your-estate/).
6) Installment sale to family (bargain sale with note)
- What it does: The owner sells the property to a family member over time at fair market value and takes a promissory note. This produces buyer basis equal to the purchase price and spreads seller gain over time.
- Best for: Families where the buyer can afford payments and both sides want a cleaner tax basis for the buyer.
- Tradeoffs: Must be structured at arm’s length, and below‑market interest rules (e.g., Applicable Federal Rates) apply; consult a tax attorney.
7) Selling to an intentionally defective grantor trust (IDGT)
- What it does: The seller (grantor) sells the property to a defective trust in exchange for a note. The sale is ignored for income tax purposes, but future appreciation occurs outside the grantor’s estate.
- Best for: Sophisticated estate plans wanting to move future appreciation out of an estate while keeping settlement income tax treatment favorable.
- Tradeoffs: Complex, needs expert counsel and precise drafting.
Practical examples (simplified) that I use in planning sessions
Example A — Carry‑over basis pain:
- Parent bought rental property decades ago for a low price. They gift it to their adult child while alive. Child inherits carry‑over basis and later sells for a large gain, paying capital gains tax on years of appreciation.
Example B — Step‑up benefit:
- Same rental property, but the parent holds it until death. The estate administrator transfers the property to the child with a basis stepped up to current market value, significantly reducing capital gains on immediate sale.
Example C — Life estate example:
- Parents transfer remainder interest to children but retain life estate. Parents live in the house until death; children receive remainder and typically benefit from a partial step‑up at the parents’ death when the life estate ends (valuation can be tricky—get an appraisal and legal drafting right).
Each example requires careful documentation and often appraisals; I advise clients to involve CPAs and estate attorneys early in the process.
Steps to implement a tax‑basis strategy (checklist)
- Inventory assets and document original purchase prices, improvements, and depreciation records. Basis depends on acquisition cost plus capital improvements minus depreciation.
- Get professional appraisals when gifting or estate planning to support valuations.
- Discuss objectives (income needs, legacy goals, Medicaid or creditor concerns) before choosing a tool.
- Coordinate with a CPA and estate planning attorney to draft trusts, deeds, or sale documents.
- File required returns (e.g., Form 709 for gifts above the annual exclusion; estate tax return Form 706 if applicable).
- Revisit the plan periodically—laws and personal circumstances change.
IRS forms and publications to review: Publication 551 (Basis of Assets) and the IRS Estate & Gift Taxes web pages for current filing thresholds and exemptions (irs.gov). Keep in mind annual gift exclusions and lifetime exemption amounts change and are adjusted for inflation or legislation.
Common mistakes I see (and how to avoid them)
- Mistake: Gifting without considering carry‑over basis. Fix: Calculate the recipient’s likely capital gain and estimate the tax before gifting.
- Mistake: Assuming state rules mirror federal rules. Fix: Check your state’s inheritance, estate, and gift tax rules—some states have estate or inheritance taxes even if federal exposure is low.
- Mistake: Poorly drafted deeds and trust funding. Fix: Always record deeds properly and confirm assets are retitled into trusts when intended.
- Mistake: Ignoring Medicaid look‑back and long‑term care planning. Fix: Coordinate asset transfers with long‑term care strategy if applicable.
Frequently asked tactical questions
- Can you step up basis for a property you gave away during life? Generally no—the step‑up applies at death for property in the decedent’s estate. There are limited technical exceptions and trust drafting techniques that can affect estate inclusion; consult counsel.
- What about depreciated rental property? Depreciation recapture rules may cause ordinary income upon sale; basis calculations must include accumulated depreciation reductions—discuss this with your CPA.
- How do annual gifts affect basis? Each gifted portion carries donor basis; the annual exclusion reduces gift tax exposure but not basis carryover.
Interactions with estate and gift taxes
Basis strategies are often used in tandem with estate and gift tax planning. A useful primer on federal gift and estate taxes—filing requirements, exemptions, and interactions with basis rules—is available on FinHelp’s “Estate and Gift Tax Basics” page: https://finhelp.io/glossary/estate-and-gift-tax-basics-when-federal-rules-apply/.
Additionally, when your goal is to preserve value for heirs by achieving a step‑up where possible, review our deeper explainer on the mechanics of a “step‑up in basis” (https://finhelp.io/glossary/step-up-in-basis/).
Final considerations and professional posture
Tax basis strategy is rarely one‑size‑fits‑all. My rule: start with objectives (who needs income, who will likely sell, liquidity needs, and health/care risks), then pick the legal vehicle that best balances tax, control and family dynamics. Complex tools like GRATs, IDGTs, and sales to trusts work well, but they require precise drafting and coordination among attorneys, appraisers, and tax advisors.
Professional disclaimer: This article is educational only and does not constitute legal, tax, or investment advice. Rules about basis, gift, and estate taxes change—consult a licensed CPA or estate planning attorney to design and implement a plan tailored to your situation.
Author note: In my practice I routinely run after‑tax scenarios for clients before recommending a basis strategy; small changes in timing or valuation can change the recommendation. If you want a practical checklist or worksheet I use with clients, consider contacting a qualified advisor to run your numbers.
Authoritative resources
- IRS Publication 551, Basis of Assets: https://www.irs.gov/publications/p551
- IRS Estate and Gift Taxes overview: https://www.irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes
Internal links
- More on step‑up rules: “Step‑Up in Basis” — https://finhelp.io/glossary/step-up-in-basis/
- Life estate pros and cons: “Granting a Life Estate: Pros, Cons, and Tax Effects” — https://finhelp.io/glossary/granting-a-life-estate-pros-cons-and-tax-effects/
- Estate and gift tax primer: “Estate and Gift Tax Basics: When Federal Rules Apply” — https://finhelp.io/glossary/estate-and-gift-tax-basics-when-federal-rules-apply/
(Last reviewed by author: 2025).
