California Step-up In Basis: Avoiding Costly Capital Gains Taxes

What is Step-Up in Basis and Why Is It Important?

The step-up in basis rule can dramatically reduce capital gains tax when an asset is sold after inheritance. Normally, capital gains are calculated based on the original cost of the asset, not the current value. However, when an asset receives a step-up in basis when a person dies, that cost is readjusted based on the asset’s current market value rather than the original cost. This can be critical, since a piece of real estate that was bought, for example, in the 1990s, could save thousands (if not millions) of dollars in capital gains tax.

Example

Your parents bought a house for $100,000 ten years ago and the house is worth $500,000 when they die. Without a step-up in basis, if the house was sold there would be a capital gains tax on the $400,000 of appreciation. But with a proper strategy, when you inherit the house the basis (cost) is automatically stepped up to the current value. If you then turn around and sell it for the same price, $500,000, you pay no capital gains tax.

Holding Title and Step-Up in Basis

How a property’s title is held can change the tax result. These are the three common ways title can be held in California: joint tenancy, tenancy in common, and community property with a right of survivorship.

Joint Tenancy (Married)

A joint tenancy is when each tenant has equal rights and equal ownership of the property. One of the most important rules in joint tenancies is that when one tenant dies, their interest automatically devolves to the survivors. This is known as a right of survivorship. The basis of the deceased tenant’s interest (50%) is stepped up to fair market value, alongside the original cost basis of the survivor’s interest at the moment of death.

Example: Hank and Wendy buy a house for $200,000. Hank later dies when the house is worth $800,000. Hank’s original basis of $100,000 would be stepped up to $400,000 (half of $800,000). If Wendy then sold the house for $800,000, she would pay capital gains on $300,000: the difference between her own original basis of $100,000 and Hank’s stepped-up basis of $400,000, against the current value of $800,000.

Tenancy in Common

In a tenancy in common, each owner has a separate and distinct share of the property. Unique to this type of interest, owners do not need equal ownership rights. Upon the death of an owner, their basis is stepped up based on their interest in the property.

Example: Alice and Bob purchased a house for $1,000,000. Alice paid $400,000 and Bob paid $600,000, so Alice has a 40% interest and Bob has a 60% interest. Alice later dies when the value of the property has grown to $2,000,000. Alice’s original basis of $400,000 would be stepped up to $800,000.

Community Property with a Right of Survivorship

Community property is an ownership presumption for married couples in California. With a right of survivorship included, when a spouse dies the surviving spouse inherits any interest in the deceased spouse’s share. What is unique about holding the title this way is that there are two step-ups in basis: the property is stepped up when the first spouse dies and again when the second spouse dies.

Example: Harry and Wilma purchase a house for $400,000. Harry dies when the property is worth $600,000, and the property’s basis steps up to $600,000. Wilma later dies when the property is worth $800,000. Because the house was titled as community property with a right of survivorship, the estate receives a second step-up to $800,000 and no capital gains would be owed if the property is sold.

Conclusion

Understanding the step-up in basis and how it interacts with different forms of property ownership is crucial for effective estate planning. It can save your beneficiaries significant amounts in capital gains tax. Far too often, when homes are purchased, the options of which title to select aren’t adequately explained, especially the future tax consequences. Your heirs will be grateful for not paying these taxes. With that in mind, it’s recommended you consult with an estate planning attorney to understand the best strategies for your specific situation.