You may have heard of stepped up basis, but might not actually know how it works. It is a technical accounting term that is critical to determining any gain or loss when a decedents assets are eventually sold.
There are many issues associated with an estate when someone passes away, but determining fair market value and using this for step up basis is very critical.
You often see, stepped up basis, as it relates to stocks and bonds. But in fact, it relates to all assets of the person who passed away.
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How to get ‘Stepped up’ basis
You should have an appraisal done or evaluation on all assets to make sure that you’ve got a reasonable approach to determining fair market value. You also need to consider the materiality of the asset.
If mineral rights are a large portion of the decedents estate then it makes sense to have a very formal appraisal. However, if there are very small royalties or minerals, then it might make sense to use a more cost-effective approach to determining at date of death.
To obtain a stepped-up basis for mineral rights upon death, you will need to determine the fair market value of the mineral rights at the time of the original owner’s death. The “stepped-up” basis essentially resets the cost basis of the inherited mineral rights to this market value, which can significantly reduce capital gains taxes if the rights are later sold by the heirs.
A “stepped-up basis” refers to an adjustment made to the cost basis of an asset when it is inherited. The cost basis is the original value of an asset for tax purposes, usually determined by the purchase price or investment cost.
When an asset is passed down to an heir upon the death of the original owner, the IRS allows the basis of the asset to be “stepped up” to its fair market value as of the date of the owner’s death. This adjustment is especially beneficial when the asset has appreciated in value over time.
Example of Stepped Up Basis
For example, if someone inherits mineral rights that were originally purchased for $50,000 but are worth $200,000 at the time of the owner’s death, the stepped-up basis would be $200,000.
This new basis reduces the capital gains tax liability if the heir later sells the asset, because the gain will be calculated based on the difference between the sale price and the stepped-up basis, rather than the original purchase price.
The purpose of the stepped-up basis is to minimize the tax burden on heirs, as it prevents them from being taxed on the increase in value that occurred before they inherited the asset. This tax rule can apply to many types of assets, including real estate, stocks, and mineral rights.
Here’s how to achieve this:
1. Get a Professional Appraisal
The first step in determining the stepped-up basis is to hire a qualified appraiser who specializes in mineral rights. The appraiser will evaluate the fair market value of the mineral rights as of the date of the original owner’s death.
This valuation will consider factors such as the type of minerals, location of the mineral rights, potential for future production, market demand, and any existing leases or royalties. The appraisal report will provide the fair market value, which becomes the new cost basis for the heirs.
2. Document the Valuation
Once the appraisal is completed, it is important to keep thorough records, including the appraisal report and any supporting documentation that was used to determine the fair market value. These documents are critical for tax purposes, as they substantiate the new basis if the mineral rights are sold in the future.
The stepped-up basis will apply to the heirs, meaning any capital gains taxes owed upon the sale will be calculated based on the difference between the sale price and the stepped-up basis, rather than the original purchase price.
3. Report the Stepped-Up Basis to the IRS
When you inherit mineral rights and use the stepped-up basis, it is necessary to report this to the IRS if the rights are sold. The fair market value determined by the appraisal will be used to calculate any capital gains or losses on the sale.
You do not need to report the stepped-up basis unless the rights are sold, but having proper documentation ready is essential in case of an audit or other IRS inquiry.
By obtaining a professional appraisal and documenting the fair market value of the mineral rights at the time of the original owner’s death, heirs can ensure they take advantage of the stepped-up basis for tax purposes. This can significantly reduce capital gains taxes when the rights are eventually sold and help preserve more of the inheritance’s value.