How Step-Up in Basis Works in California

When an individual inherits an asset, its value for tax purposes is adjusted to the fair market value at the time of the previous owner’s death. This rule, known as a “step-up in basis,” can reduce the capital gains tax owed when the heir eventually sells the asset. The adjustment erases the taxable gain that accumulated during the decedent’s lifetime, meaning the heir is only responsible for taxes on appreciation that occurs after they inherit the property.

An asset’s basis is its original cost, which is used to calculate the capital gain or loss upon its sale. For example, if a home was purchased for $200,000 and is worth $1 million at the owner’s death, the heir’s new basis becomes $1 million. Should the heir sell the property for $1.1 million, the taxable capital gain would only be $100,000, not the $900,000 of appreciation that occurred during the original owner’s life.

An exception to this rule affects assets held within certain irrevocable trusts. If an asset is held in an irrevocable trust and is not included in the deceased person’s taxable estate, it does not receive a step-up in basis. In these cases, the heir inherits the original owner’s cost basis, which could lead to a larger capital gains tax upon its sale.

How Step-Up in Basis Functions in California

California conforms to federal rules for step-up in basis, but its status as a community property state creates a distinction for married couples. The treatment of inherited assets depends on whether the property is classified as separate or community property. This classification determines how an asset’s basis is adjusted upon a spouse’s death, impacting the surviving spouse’s capital gains tax.

Separate property is anything owned by a spouse before the marriage, or received during the marriage by gift or inheritance. When a spouse dies, only the decedent’s portion of separate property receives a step-up in basis. For instance, if a spouse owned a 50% interest in a rental property as their separate property, only that 50% share would be adjusted to its fair market value, while the survivor’s share retains its original cost basis.

A more advantageous treatment applies to community property, which includes all assets acquired by a couple during their marriage while living in California. When one spouse dies, both halves of the community property receive a full step-up in basis. This is often called a “double step-up” and provides a tax benefit to the surviving spouse.

Consider a couple who purchased a home in California for $500,000. Years later, when one spouse passes away, the home’s fair market value has risen to $1.5 million. The entire property gets a new basis of $1.5 million. If the surviving spouse then sells the home for $1.55 million, their taxable capital gain is only $50,000. In a common-law state, only the decedent’s half would step up, resulting in a new basis of $1 million and a much larger taxable gain.

Distinguishing Basis from Property Tax Assessment

For California heirs, it is important to distinguish between the step-up in basis for capital gains and the assessed value for property taxes. These are two separate valuations for different tax purposes. The step-up in basis is a federal income tax concept used to calculate profit when an inherited asset is sold and has no bearing on an heir’s annual property tax bill.

California property tax is governed by state law, and rules for reassessment changed with Proposition 19 in 2021. Before this, parents could transfer a primary residence and other real estate to their children without triggering a property tax reassessment. This allowed children to inherit their parents’ lower property tax base.

Under Proposition 19, the parent-child exclusion is limited. For an inherited home to retain its parent’s lower assessed value, the heir must use it as their primary residence within one year of the inheritance. The exclusion is also capped; if the home’s market value at the time of transfer exceeds the original assessed value by more than $1 million, the property will be reassessed. Any inherited property not used as the heir’s primary residence is automatically reassessed to its full market value.

An heir can receive a full step-up in basis for capital gains purposes while facing a higher annual property tax bill due to reassessment. The favorable outcome for one tax does not influence the other.

Required Documentation and Valuation

To benefit from the step-up in basis, the executor or heir must establish the fair market value (FMV) of inherited assets as of the decedent’s date of death. This valuation requires specific documentation to substantiate the new basis to the IRS, and the process differs by asset type.

For real estate, the best method for determining FMV is a formal appraisal from a state-licensed real estate appraiser, dated as of the date of death. The appraisal report provides the defensible evidence the IRS requires and becomes a permanent record for the property.

For publicly traded securities, the FMV is determined by averaging the highest and lowest selling prices on the date of death. This information is found on the brokerage statements issued for the decedent’s account, which serve as the primary documentation.

In addition to valuation reports, an heir must secure other documents and keep meticulous records for future tax reporting.

• A certified copy of the death certificate to establish the date of death.
• The decedent’s will or trust documents to confirm who legally inherited the assets.
• Formal appraisal reports for real estate.
• Brokerage statements for financial assets.

Reporting the Sale of Inherited Property

When an heir sells an inherited asset, the transaction must be reported to the IRS on their income tax return for the year of the sale. The primary form for this is IRS Form 8949, Sales and Other Dispositions of Capital Assets. On this form, the seller reports the property description, the date it was acquired (by writing “inherited”), the sale date, and the sales proceeds. The seller enters the stepped-up basis in the column for cost.

The information from Form 8949 is used to calculate the capital gain or loss, which is summarized on Schedule D, Capital Gains and Losses. A gain occurs if the sales price is higher than the stepped-up basis, while a loss occurs if it is lower. For inherited assets, the gain or loss is automatically considered long-term, which can result in more favorable tax rates.

If an estate tax return was filed, the basis used by the heir must be consistent with the value reported on that return. The executor of the estate may also provide beneficiaries with a form that formally reports the final value of the inherited property. This document provides the official basis that the heir must use when reporting the sale.