How is the basis of inherited Virginia real estate determined for a capital gain/loss on the state income tax return when the taxpayer's appraisal and the locality's tax appraisal disagree?

Plain-English summary

A husband and wife appealed a Virginia individual income tax assessment for 2014. The husband had inherited a one-quarter interest in real property from his mother, who died intestate in 2008; his three siblings inherited the other three-quarters. In 2014, the siblings sold their interests to the husband, and on the same day he sold the whole property to an unrelated buyer. On their federal return (which flows into Virginia's FAGI starting point), the taxpayers reported a capital loss, using a March 2007 appraisal (about 15 months before the decedent's death) as the property's basis.

The Department instead used the county's real estate tax appraisal as the basis, which produced a capital gain and an additional assessment. The taxpayers appealed under § 58.1-1821, arguing their 2007 appraisal was the correct basis.

The Tax Commissioner sided with neither party outright. The taxpayers' evidence fell short because they submitted only a letter from the appraiser (not the actual appraisal report) and never produced the decedent's federal estate tax return, and because the valuation was from 15 months before death -- beyond what IRS rules permit for basis purposes. But the Department's own approach was also flawed: a locality's real estate tax assessment is not necessarily a reliable measure of fair market value, though it can be useful as corroborating evidence. The Commissioner also rejected the taxpayers' fallback argument that the price paid to buy out the siblings' interests should set the basis, since that purchase (between siblings, immediately followed by a resale) raised real doubts about whether it was an arm's-length transaction. The result: the case was sent back to the Department's audit staff to gather better documentation of the property's fair market value at the date of death, with the assessment to be adjusted once that evidence is in.

What this means for you

Individuals who inherit real property

The basis of property you inherit is generally its fair market value on the date the person died, not what you or a family member paid for it later and not necessarily what the local tax assessor says it's worth. If you plan to rely on an appraisal for that basis, get (and keep) the full appraisal report -- not just a letter stating a number -- and make sure it is reasonably close in time to the date of death, consistent with IRS timing rules.

People buying out siblings' or co-heirs' inherited shares

If you buy out family members' inherited interests and then quickly resell the property, expect the Department to scrutinize whether that internal purchase price reflects fair market value. Transactions between relatives, especially ones immediately followed by a resale to an outside buyer, can be treated as not arm's-length, which undermines using that purchase price as your basis.

Accountants and tax professionals

This ruling is a reminder that Virginia's FAGI conformity (§ 58.1-301) pulls federal basis rules like IRC §§ 1001, 1012, and 1014(a)(1) directly into the Virginia income tax computation. When advising on inherited-property sales, document the date-of-death fair market value with an actual appraisal report (or the estate tax return, if one was filed) rather than relying on local real estate tax assessments or informal appraiser correspondence, since neither carries much weight on its own with the Department.

Taxpayers currently disputing a Virginia assessment

This case shows the Commissioner will decline to simply pick a side when both parties' valuation evidence is weak. Instead of resolving the substantive dispute outright, the Department returned the matter to its audit staff for further fact-finding -- so an appeal under § 58.1-1821 can result in a remand for more documentation rather than an immediate win or loss.

Common questions

Q: Did the taxpayers win their appeal?
A: Not outright. The Tax Commissioner rejected the Department's use of the county's real estate assessment as the basis, but also found the taxpayers' evidence (an appraiser's letter, not the full appraisal report, from 15 months before death) insufficient. The case was sent back to the Department's audit staff to gather proper documentation, with the assessment to be adjusted based on what that evidence shows.

Q: Why didn't the Department just accept the taxpayers' 2007 appraisal?
A: The taxpayers provided only a letter from the appraiser stating a value, not the actual appraisal report, and never produced the decedent's federal estate tax return. The Department also found the appraisal was too remote in time -- about 15 months before the decedent's death -- to satisfy IRS timing rules for date-of-death valuations.

Q: Why couldn't the Department just use the county's tax assessment as the basis?
A: Under § 58.1-3280, a locality's real property appraisal is used to determine local real estate tax liability, but the ruling notes (citing Frazee v. Commissioner) that a tax-assessed value is not necessarily a reliable measure of fair market value, though it can serve as corroborating evidence.

Q: What about the price the husband paid his siblings for their shares?
A: The Commissioner found that basis argument questionable too. The purchase was between siblings and was immediately followed by resale of the whole property to an outside buyer -- circumstances that raised doubts about whether the sibling transaction was conducted at arm's length, per Revenue Ruling 89-102.

Q: What happens next in a case like this?
A: The Commissioner returned the case to the Department's audit staff to obtain proper documentation (such as an actual appraisal report or the estate tax return) of the property's fair market value at the date of death, and the assessment will be adjusted as required by law based on that additional evidence.

Citations and references

• § 58.1-1821, Code of Virginia (application for correction of an assessment)
• § 58.1-301, Code of Virginia (conformity of Virginia terminology to the Internal Revenue Code)
• § 58.1-3280, Code of Virginia (use of a locality's real property appraisal for real estate tax purposes)
• IRC § 1014(a)(1) (basis of property acquired from a decedent)
• Treas. Reg. § 1.1014-3 (fair market value for basis based on federal estate tax appraisal)
• 26 CFR § 20.6011-1 (requirement to file a federal estate tax return)
• IRC § 1001 (gain from sale of property is amount realized over adjusted basis)
• IRC § 1012 (basis of property is generally its cost)
• Revenue Ruling 89-102 (1989) (basis adjustments for non-arm's-length or peculiar-circumstance transactions)

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 20-157

Original ruling text

September 8, 2020

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will respond to your letter in which you seek correction of the individual income tax assessment issued to * (the “Taxpayers”) for the taxable year ended December 31, 2014.

FACTS

The Taxpayers, a husband and wife, resided in Virginia during the taxable year at issue. * (the “Decedent”) owned real property in Virginia. When she died intestate in June 2008, the husband and his three siblings, as heirs of her estate, each received a one-quarter interest in real property owned by the decedent.

During 2014, the siblings sold their interests in the real property to the husband. That same day, the husband sold the property to an unrelated third party. The Taxpayers claimed a capital loss on their 2014 federal income tax return from the sale of the property utilizing the value from a March 2007 appraisal as the basis. The loss was reflected in the federal adjusted gross income (FAGI) on their Virginia return.

Upon review, the Department adjusted the basis of the property to the amount appraised by * (the “County”), resulting in a capital gain and the assessment of additional income tax. The Taxpayers appeal, contending they properly used the March 2007 appraised value as the basis.

DETERMINATION

Virginia Code § 58.1-301 provides, with certain exceptions, that the terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia . For individual income tax purposes, Virginia “conforms” to federal law, in that it starts the computation of Virginia taxable income (VTI) with FAGI. Income properly included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Chapter 3 of Title 58.1 of the Code of Virginia .

Inherited Property Basis

The Taxpayers contend that based on the 2007 appraisal, the basis of the property when the decedent died was greater than the sale price of the property. As such, the transaction resulted in a capital loss.

Generally, the basis of property passing from a decedent after her death is the fair market value of the property at the date of the decedent’s death. See IRC § 1014(a)(1). The value of property appraised for the federal estate tax is deemed to be the fair market value for purposes of determining basis. See Treas. Reg. § 1.1014-3. Pursuant to 26 CFR § 20.6011-1, with certain exceptions, a federal estate tax return must be filed for all estates.

The Department requested that the Taxpayers provide the appraisal report and the Decedent’s federal estate tax return. The Taxpayers did not provide either the appraisal report or the Decedent’s estate tax return, but instead have sent a letter from the appraiser specifying the appraised value of the property. The Department does not consider a letter from an appraiser stating the value of property in lieu of an actual appraisal report as sufficient evidence of valuation. Regardless, the property was valued 15 months prior to the decedent’s death, which was beyond the time permitted under IRS rules.

The Department used the County’s appraisal of fair market value to determine the basis of the subject property. Pursuant to Virginia Code § 58.1-3280, a locality’s appraisal of the value of real property is used to ascertain real property tax liability. The amount for which real property was assessed for purposes of local taxation, however, is not necessarily a reliable criterion to be used in estimating its fair market value. See Frazee v. Commissioner , 98 T.C. 554, 563 (1992). In appropriate circumstances, tax-assessed values can be useful as a guideline or as corroboration of other evidence of fair market value. See Kellahan v. Commissioner , T.C. Memo 1999-210. In the case where the Department doubts the validity of a Taxpayer’s valuation, it must likewise determine an estimate of fair market value in accordance with IRS regulations.

Basis from Sale

In the alternative, the Taxpayers believe the basis of the real estate at the time of the sales is an appropriate valuation. Pursuant to IRC § 1001, the gain from the sale of property is the amount realized over the adjusted basis. The basis of property is generally the cost of such property. See IRC § 1012. The Taxpayers purchased the husband’s siblings’ interests in the property just prior to the sale to the unrelated third party. As such, the basis of the property interests purchased from the husband’s siblings should be the amount the Taxpayers paid. Adjustments to basis, however, are justified where, for instance, transactions between related parties are not conducted at arm’s length or where a transaction is based upon “peculiar circumstances” that influence the purchaser to agree to a price in excess of the property’s fair market value. See Revenue Ruling 89-102 (1989).

In this case, because the purchase was made between siblings, it is questionable whether they were made at arm’s length. There is no evidence of the fair market value of the siblings’ interest in property at the time of the sale. In addition, the fact that the property was immediately resold after the purchase of the siblings’ interest would qualify as a “peculiar circumstance.” No doubt, the siblings were aware of the Taxpayer’s plan to resell the entire property after their transaction, impacting their negotiating position.

CONCLUSION

While the Department cannot agree to the valuation set forth by the Taxpayers, reliance on a locality’s valuation for real estate taxes does not meet the standard of valuation required of the IRS in such cases. Accordingly, the case will be returned to the Department’s audit staff in order to acquire documentation or other evidence showing the fair market value for the subject property at the time of the Decedent’s death. Adjustments to the assessment as required by law will be made based on the additional documentation, as appropriate.

The Code of Virginia sections cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/3316.B