Step-Up in Basis at Death of Spouse in California Rental Property

When a spouse passes away, the surviving partner may receive a step-up in basis on jointly owned assets, including rental property. This adjustment can significantly impact capital gains taxes when selling the property. Understanding how this applies in California is particularly important due to the state’s community property laws, which differ from those in common law states.

The step-up depends on how the property was owned. Determining the new basis and documenting fair market value are essential for tax reporting and future sale calculations.

California Community Property Basis

California follows community property laws, meaning most assets acquired during a marriage are jointly owned. This affects the step-up in basis when one spouse dies. Unlike common law states, where only the deceased spouse’s share receives a step-up, California allows a full adjustment of the property’s basis to its fair market value at the date of death.

This full step-up is based on Internal Revenue Code (IRC) Section 1014(b)(6), which states that if property is classified as community property, both spouses’ interests receive a basis adjustment. For example, if a couple bought a rental property for $500,000 and its value increased to $1.2 million at the time of one spouse’s death, the entire basis would be stepped up to $1.2 million. This eliminates unrealized capital gains up to that point, reducing potential tax liability if the surviving spouse later sells the property.

To qualify, the property must be community property under California law, meaning it was acquired during the marriage using marital funds. If purchased before marriage or received as a gift or inheritance, it may be considered separate property unless formally converted. Proper titling is also important—holding the property as “community property with right of survivorship” ensures a seamless transfer and step-up in basis without probate.

Full vs Partial Step-Up Rules

The tax treatment of a step-up in basis depends on ownership structure. In California, community property receives a full step-up, meaning both halves of the basis are adjusted to fair market value when a spouse dies. In contrast, property held in joint tenancy receives only a partial step-up, where only the deceased spouse’s share is adjusted, leaving the surviving spouse with a mixed basis—half at the original purchase price and half at the stepped-up value.

For example, if a rental property was purchased for $600,000 and appreciated to $1.5 million at the time of one spouse’s death, the tax implications depend on ownership. If the property was community property, the entire basis resets to $1.5 million. If held in joint tenancy, only the deceased spouse’s 50% share steps up, resulting in a new basis of $1,050,000—half at $600,000 and the other half at $750,000. This difference affects capital gains taxes when selling, as a partial step-up leaves some of the original gains taxable.

Some couples unknowingly hold property in joint tenancy rather than community property, missing out on the full step-up benefit. Converting joint tenancy assets to community property before a spouse’s death can be beneficial but requires proper legal documentation. California law allows reclassification through a written agreement or by retitling the property as “community property with right of survivorship.” Estate planning attorneys can assist with these changes.

Determining New Basis for Rental Property

Establishing the new basis for a rental property after a spouse’s passing requires assessing fair market value and adjusting for improvements and depreciation. The fair market value at the date of death serves as the starting point, but any improvements made afterward increase the basis, while prior depreciation deductions reduce it. This adjusted basis affects depreciation schedules and capital gains upon sale.

Depreciation recapture is a key factor. The IRS requires landlords to depreciate residential rental property over 27.5 years using the Modified Accelerated Cost Recovery System (MACRS). If the deceased spouse had been claiming depreciation, those deductions lower the property’s basis. However, after the step-up, depreciation starts fresh from the new basis, eliminating prior accumulated depreciation and potentially reducing tax liabilities related to recapture under IRC Section 1250. This can be beneficial if the surviving spouse continues renting out the property.

In some cases, the estate might claim an alternate valuation date, six months after death, under IRC Section 2032. This option is available only if it reduces both the gross estate value and estate tax liability. If property values decline during this period, electing the alternate valuation could result in a lower step-up basis, which may not be ideal for future capital gains planning. Consulting a tax professional can help determine whether this election is beneficial.

Documentation of Fair Market Value

Accurately establishing the fair market value (FMV) of a rental property at the date of a spouse’s death is necessary for tax compliance and financial planning. The IRS requires defensible evidence to support the valuation, as an incorrect basis could lead to audit challenges or unexpected tax liabilities. A formal appraisal is the most reliable approach, as a certified real estate appraiser provides an analysis of market conditions, comparable sales, and property-specific attributes to determine an objective value.

Other supporting documentation can help substantiate the valuation, particularly if an appraisal was not obtained at the time. Comparable sales data from real estate platforms, broker price opinions, or county tax assessor records can serve as secondary evidence. If the property generates rental income, a capitalization rate analysis—dividing net operating income by a market-derived cap rate—can provide an additional valuation method. The IRS may scrutinize valuations that significantly differ from local market trends, making it important to use multiple sources when justifying FMV.

Calculating Potential Gains on Sale

Once the new basis has been determined, calculating potential gains when selling the rental property is straightforward. The capital gain is the difference between the sale price and the adjusted basis, minus selling costs such as real estate commissions, escrow fees, and legal expenses. Since California provides a full step-up in basis for community property, the surviving spouse may significantly reduce or even eliminate taxable gains if the property is sold shortly after the step-up occurs.

Long-term capital gains tax rates apply to property held for more than a year, with federal rates ranging from 0% to 20%, depending on income. California does not have a separate capital gains tax rate—profits are taxed as ordinary income, with rates reaching as high as 13.3% for high earners. Depreciation recapture is another factor, as prior deductions are taxed at a federal rate of up to 25%. Properly timing the sale and utilizing strategies such as a 1031 exchange can help defer or minimize tax liabilities.

Tax Reporting After the Step-Up

Once the step-up in basis has been applied, the surviving spouse must ensure proper tax reporting to avoid discrepancies with the IRS. The new basis must be documented on future tax returns, particularly when calculating depreciation if the property continues to be rented. The IRS requires that depreciation be recalculated using the stepped-up basis, which can lower taxable rental income in subsequent years.

If the property is eventually sold, the adjusted basis must be reported on Schedule D and Form 8949 of the federal tax return. Any depreciation recapture is reported on Form 4797. The surviving spouse should also ensure that any estate tax filings, such as Form 706, properly reflect the fair market value used for the step-up. Keeping thorough records, including the appraisal and any supporting valuation documents, is necessary in case of an IRS audit.