What Happens to Cost Basis if you Inherit a Seller Financed Note?

Tax, SDIRAs & Cost Segregation
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What Happens to Cost Basis if you Inherit a Seller Financed Note?

Christopher Freeman
Rental Property Investor · Keene, NH · Member since 2018 · 115 posts · 73 votes

I'm wondering what the tax implications are for the heirs of a seller who dies while carrying the note on a seller financed deal.

For example, suppose a seller has a fully depreciated asset with a $50k cost basis from the value of the land. They sell for $250k. In a cash or bank financed deal, they show a capital gain of $200k.

My understanding is that if the seller were to carry the note, they would be able to spread the capital gains tax.

My question is: What happens if the seller dies before the note has been fully repaid and the note passes to the seller's heirs? Do the heirs receive a stepped up basis in the asset with which the note is collateralized, or will they continue to pay the gain on behalf of the decedent?

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William Hochstedler
Broker · Logan, UT · Member since 2013 · 1k+ posts · 1k+ votes
7y

@Ashish Acharya

What is the maximum equitable interest a buyer can gain while preserving the seller's heirs' ability to get a stepped up cost basis on death?  (Specifically addressing what triggers a "sale" or taxable event with Lease/Options or contracts for deed.)

This isn't really about buyer's or seller's perspective.  I'm talking to grandma.  I want to buy it and she wants to sell it.  We both want to structure it in the best way for her estate while giving me ultimate ownership at a price we agree on today.  If the only way to take advantage of the stepped-up basis is to wait to get fee simple title until her death, I can wait.  But how would you structure that scenario?

If Grandma has a 20%+ capital gains liability she wants more money from me for the taxman.  In other words, it's not buyer against seller, it's buyer and seller against taxman.

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  • Lance LvovskyPro Member
    Accountant · Fort Lauderdale, FL · Member since 2013 · 1k+ posts · 753 votes
    8y
    @Christopher Freeman Cost basis gets stepped up to date of death value on an asset (generally speaking). For a note, cost basis is the amount outstanding on the note. The date of death value is the cost basis plus accrued interest through date of death (this is applicable to estate tax return).
    0Reply
  • Christopher Freeman
    OP
    Rental Property Investor · Keene, NH · Member since 2018 · 115 posts · 73 votes
    8y

    @Lance Lvovsky, what happens to the capital gains associated with the sale? Am I correct in my understanding that in an installment sale the capital gains is not all due at once?

    0Reply
  • Lance LvovskyPro Member
    Accountant · Fort Lauderdale, FL · Member since 2013 · 1k+ posts · 753 votes
    8y

    On an installment sale, capital gains are not all due at once, since you are receiving proceeds from the sale over a period of time, and are taxed accordingly.

    0Reply
  • Christopher Freeman
    OP
    Rental Property Investor · Keene, NH · Member since 2018 · 115 posts · 73 votes
    8y
    @Lance Lvovsky, so if the seller dies before the transaction is complete, do their children still have to pay the capital gains as though the seller had not died, or does their residual interest get a stepped up basis?
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  • Lance LvovskyPro Member
    Accountant · Fort Lauderdale, FL · Member since 2013 · 1k+ posts · 753 votes
    8y

    I would need to review the sales agreement.... with that being said... the seller has sold the property, and hence, the property is no longer an asset in hands of the seller. Rather, the seller's asset is a note receivable. Depending on how the note is titled (and whether Trusts are involved) will dictate distribution of the note. 

    There will not be a step up in basis on a note.

    You should speak to your CPA.

    0Reply
  • Christopher Freeman
    OP
    Rental Property Investor · Keene, NH · Member since 2018 · 115 posts · 73 votes
    8y
    @Lance Lvovsky, what I'm trying to learn is whether or not there is a way to structure sales agreements that would help the seller/seller's estate eliminate or mitigate capital gains tax exposure. I know that lease options can be deemed sales in reality under certain conditions, so I'm trying to explore other options.
    1Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    8y

    @Christopher Freeman , 

    I think what you were asking is what happens to the capital gain. 

    The capital gain is treated as In respect of a decedent (IRD). The gain must be reported when received by the decedent's estate or beneficiaries the same way he would report. The gain has the same character in the hands of the recipient as it had in the hands of the decedent.

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  • Daniel DietzPro Member
    Rental Property Investor · Reedsburg, WI · Member since 2011 · 1k+ posts · 857 votes
    7y

    Hello,

    @Ashish Acharya I was just googling on this topic and low and behold it took me back to BiggerPockets Forums :-)

    Am understanding correctly?

    If a property owner did NOT sell and those properties passed to their heirs at the time of death, they WOULD get 'stepped up basis'?

    But IF they sold and 'carried a mortgage via Seller Financing, the principal that remained on that Note at time of death does NOT get stepped up in the same way?

    Thanks, Dan Dietz

    [email protected]608-524-4899
    1Reply
  • Zachary Bohn
    Accountant · Englewood, OH · Member since 2019 · 87 posts · 43 votes
    7y

    @Daniel Dietz that is correct

    1Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    7y
    Originally posted by @Daniel Dietz:

    Hello,

    @Ashish Acharya I was just googling on this topic and low and behold it took me back to BiggerPockets Forums :-)

    Am understanding correctly?

    If a property owner did NOT sell and those properties passed to their heirs at the time of death, they WOULD get 'stepped up basis'?

    But IF they sold and 'carried a mortgage via Seller Financing, the principal that remained on that Note at time of death does NOT get stepped up in the same way?

    Thanks, Dan Dietz

    You got it. 

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    1Reply
  • William Hochstedler
    Broker · Logan, UT · Member since 2013 · 1k+ posts · 1k+ votes
    7y

    @Ashish Acharya @Zachary Bohn (and any other accountants)

    If the note does not get a stepped up basis, an 87 year old seller might prefer to hold title to the fully depreciated title to take advantage of the stepped up cost basis for estate purposes.  (Instead of seller financing the property and passing all the capital gains burden to her heirs, right?)

    Therefore, how do you recommend helping the seller structure this?  An option would do the trick, right?  As mentioned above, is there any risk of also entering into a master lease agreement (or property management agreement) during this period?  Would some sort of lease/option structure really jeopardize the favorable tax consequence for the heirs of inheriting the property instead of a note from seller financing? 

    What about a contract for deed where title does not transfer?  And if the contract was interest only?

    There are lots of ways to control a property without transferring title or triggering tax events.  It would be great if we could get some guidance on how to approach this very typical situation.

    Thanks!

    1Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    7y
    Originally posted by @William Hochstedler:

    @Ashish Acharya @Zachary Bohn (and any other accountants)

    If the note does not get a stepped up basis, an 87 year old seller might prefer to hold title to the fully depreciated title to take advantage of the stepped up cost basis for estate purposes.  (Instead of seller financing the property and passing all the capital gains burden to her heirs, right?)

    Therefore, how do you recommend helping the seller structure this?  An option would do the trick, right?  As mentioned above, is there any risk of also entering into a master lease agreement (or property management agreement) during this period?  Would some sort of lease/option structure really jeopardize the favorable tax consequence for the heirs of inheriting the property instead of a note from seller financing? 

    What about a contract for deed where title does not transfer?  And if the contract was interest only?

    There are lots of ways to control a property without transferring title or triggering tax events.  It would be great if we could get some guidance on how to approach this very typical situation.

    Thanks!

    Do you want to know what is best for the seller's perspective or buyer's? 

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    0Reply
  • William Hochstedler
    Broker · Logan, UT · Member since 2013 · 1k+ posts · 1k+ votes
    7y

    @Ashish Acharya

    What is the maximum equitable interest a buyer can gain while preserving the seller's heirs' ability to get a stepped up cost basis on death?  (Specifically addressing what triggers a "sale" or taxable event with Lease/Options or contracts for deed.)

    This isn't really about buyer's or seller's perspective.  I'm talking to grandma.  I want to buy it and she wants to sell it.  We both want to structure it in the best way for her estate while giving me ultimate ownership at a price we agree on today.  If the only way to take advantage of the stepped-up basis is to wait to get fee simple title until her death, I can wait.  But how would you structure that scenario?

    If Grandma has a 20%+ capital gains liability she wants more money from me for the taxman.  In other words, it's not buyer against seller, it's buyer and seller against taxman.

    3Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    7y
    Originally posted by @William Hochstedler:

    @Ashish Acharya

    What is the maximum equitable interest a buyer can gain while preserving the seller's heirs' ability to get a stepped up cost basis on death?  (Specifically addressing what triggers a "sale" or taxable event with Lease/Options or contracts for deed.)

    This isn't really about buyer's or seller's perspective.  I'm talking to grandma.  I want to buy it and she wants to sell it.  We both want to structure it in the best way for her estate while giving me ultimate ownership at a price we agree on today.  If the only way to take advantage of the stepped-up basis is to wait to get fee simple title until her death, I can wait.  But how would you structure that scenario?

    If Grandma has a 20%+ capital gains liability she wants more money from me for the taxman.  In other words, it's not buyer against seller, it's buyer and seller against taxman.

    There should not be a sale if you want to inherit and step-up basis the property. Option to sale does no good as option by nature requires the sale, and we are not looking to trigger sale at all. 

     A true lease and subsequent master lease is ok but it does not help with your grandma trying to sell it. 

    [email protected]941-914-7779
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    1Reply
  • William Hochstedler
    Broker · Logan, UT · Member since 2013 · 1k+ posts · 1k+ votes
    7y

    @Ashish Acharya

    What about contracts for deed?

    0Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    7y
    Originally posted by @William Hochstedler:

    @Ashish Acharya

    What about contracts for deed?

    Contract for deed/land contract/seller financing are all installment sales. 

    If the end goal is the inheritance, there cannot be any type of ownership transfer. 

    Contract for deed transfers ownership at the purchase. 
     

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    0Reply
  • William Hochstedler
    Broker · Logan, UT · Member since 2013 · 1k+ posts · 1k+ votes
    7y

    @Ashish Acharya

    So it sounds like an option from Grandma that secures my right to buy it from the heirs is the only way to do this.

    Did you have something else in mind when you asked which party's perspective the transaction should benefit?

    Thanks for all the clarifications.

    1Reply
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