Inherited LTR Gets $217K Year 1 Deduction via Stepped-Up Basis Cost Seg

The Problem

This client inherited a long-term rental property upon the death of a parent. Under IRC §1014, the property received a stepped-up basis to its fair market value at the date of death, appraised at $620,000. The client's accountant began depreciating the property over 27.5 years on the stepped-up basis, starting a new depreciation schedule from the date of death. This produced annual depreciation of $19,700 ($541,500 depreciable basis after $78,500 land allocation divided by 27.5 years).

The accountant was unaware that a cost segregation study on an inherited property with a stepped-up basis could produce dramatic first-year deductions. Because the basis is "reset" to fair market value at death, the stepped-up property is treated as newly placed in service for depreciation purposes, making it eligible for cost segregation and bonus depreciation as if it were a brand-new acquisition. The client, who earned $380,000 as a hospital administrator, had the potential to generate significant losses to offset W-2 income if REPS or another passive loss exception could be established.

AE Tax Strategy

1. Cost Segregation on Stepped-Up Basis Under IRC §1014 and §168

We commissioned a cost segregation study on the inherited property using the $541,500 stepped-up depreciable basis. The study identified $217,000 (40.1% of the depreciable basis) in components eligible for reclassification: $98,000 in 5-year property, $54,000 in 7-year property, and $65,000 in 15-year property. The higher reclassification percentage (40.1% vs. the typical 30-35%) reflected the age of the property — older properties tend to have a higher proportion of components that qualify for shorter recovery periods because many original components have been replaced or upgraded over time.

2. REPS Qualification Through Spouse Under IRC §469(c)(7)

The client's spouse had recently retired from teaching and was spending significant time managing the inherited rental and two other family-owned rentals. We documented the spouse's qualification for Real Estate Professional Status: 1,420 hours in real property trades or businesses (property management, tenant relations, maintenance oversight, renovation planning) compared to zero hours in any other trade or business. We filed the REPS election and a grouping election to treat all rental properties as a single activity, with aggregate material participation established through the spouse's 1,420 hours.

3. Loss Utilization and Estate Tax Coordination

The $217,000 in bonus depreciation plus $11,800 in standard straight-line depreciation on the remaining components produced total Year 1 depreciation of $228,800. Against net rental income of $36,200, the property generated a net loss of $192,600. With REPS qualification, this loss offset the client's W-2 income. At the combined 35% federal plus 3.07% Pennsylvania flat tax rate, the $192,600 loss produced approximately $73,200 in first-year tax savings. We also coordinated with the estate attorney to ensure the stepped-up basis was properly documented with an appraisal filed with the estate tax return (even though no estate tax was due, the appraisal substantiated the depreciable basis).

Before & After Comparison

Tax Category	Before	After	Savings
Standard Depreciation (27.5-Year)	$19,700	$0	$19,700
Cost Seg Bonus Depreciation	$0	$217,000	$217,000
Net Loss Applied to W-2	$0	$192,600	$192,600
First-Year Tax Savings	$7,500	$73,200	$65,700
Total	$19,700	$228,800	$217,000 (Year 1 deduction)

Key Takeaways

• Inherited property receives a stepped-up basis to fair market value under IRC §1014, creating a brand-new depreciation schedule eligible for cost segregation and bonus depreciation.
• Older inherited properties often yield higher cost segregation reclassification percentages because many original components have been replaced with items that qualify as personal property.
• The stepped-up basis must be substantiated with a qualified appraisal — ideally obtained within 6 months of death and filed with the estate return even when no estate tax is due.
• Cost segregation on inherited property is one of the most overlooked tax planning opportunities because most CPAs do not proactively recommend it when a client inherits real estate.