For anyone inheriting real estate, particularly in California, understanding the concept of "step-up in basis" is crucial. It's a powerful tax provision that can significantly reduce, or even eliminate, capital gains taxes when you eventually sell an inherited property.

What is "Basis" in Real Estate?

In simple terms, your "basis" in a property is its cost for tax purposes. This typically includes the original purchase price, plus the cost of certain improvements, and minus any depreciation taken. When you sell a property, your capital gain (or loss) is calculated by subtracting your basis from the sale price.

• Example: If you bought a home for $500,000 (your basis) and sold it for $800,000, your capital gain would be $300,000. This $300,000 would generally be subject to capital gains tax.

How the "Step-Up in Basis" Works

When you inherit an asset, like real estate, its basis is "stepped up" to its fair market value (FMV) on the date of the previous owner's death. This means that for tax purposes, it's as if you acquired the property at its value on that date, rather than the original purchase price.

The primary implication of this step-up is to minimize or eliminate capital gains tax for the inheritor. If you sell the property shortly after inheriting it, and its value hasn't changed significantly since the date of death, your capital gain would be very small, or even zero.

The California Community Property Advantage: A Double Step-Up

This is where California's community property laws offer an even greater advantage. In community property states like California, assets acquired during a marriage are generally considered to be owned equally by both spouses.

If a married couple owns a property as community property, and one spouse passes away, the entire property (both the deceased's half and the surviving spouse's half) receives a full step-up in basis to its fair market value on the date of death.

If the surviving spouse continues to live in the home and then passes away later, the property often receives a second step-up in basis to its fair market value as of the second spouse's date of death, before it passes to the ultimate heirs.

A Clear Example:

Let's illustrate with a scenario:

• Original Purchase: John and Mary bought their San Jose home in 1980 for $150,000, holding it as community property.

• John Passes Away: John passes away in 2004. At that time, the home's fair market value (FMV) is $700,000.

  • Implication: Because they owned it as community property, the entire home's basis is stepped up to $700,000 for Mary. If Mary had sold it then, her taxable gain would be minimal (based on any appreciation after John's death).

• Mary Passes Away: Mary continues to live in the home until her passing in 2022. At her death, the home's FMV is $1,500,000.

  • Implication: The home receives a second step-up in basis to $1,500,000 for their children (the inheritors).

• Children Sell the Home: The children sell the home shortly after Mary's death for $1,510,000.

  • Taxable Gain: Their capital gain is calculated as $1,510,000 (sale price) - $1,500,000 (stepped-up basis) = $10,000.

  • Without Step-Up: If there were no step-up, their gain would have been $1,510,000 - $150,000 (original purchase price) = $1,360,000, leading to a much larger tax bill.

As you can see, the step-up in basis can save inheritors hundreds of thousands of dollars in capital gains taxes, making inherited property a highly tax-advantaged asset.

Important Disclaimer:

While the "step-up in basis" is a powerful tool, real estate and tax laws are complex and can vary based on individual circumstances, how title was held, and specific estate planning documents. This article provides general information and should not be considered tax or legal advice.

If you are inheriting or planning to sell an inherited property, it is absolutely essential to consult with a qualified tax advisor or an estate attorney to understand your specific situation and ensure compliance with all applicable laws.