Stepped Up Basis California: Rules for Inherited Assets

Basis is the original cost of an asset used to calculate taxes on a future sale. When an individual inherits an asset, the federal “stepped-up basis” rule adjusts the asset’s basis from its original purchase price to its fair market value at the time of the owner’s death. This adjustment can lower the capital gains tax owed by heirs. California follows this federal rule, but its distinct property laws can alter the outcome for beneficiaries.

The Federal Foundation of Stepped-Up Basis

Internal Revenue Code Section 1014 establishes the stepped-up basis for inherited property. This provision adjusts an asset’s value to its fair market value on the owner’s date of death, erasing the unrealized capital gains accumulated during the decedent’s lifetime. An heir who sells the asset will only owe taxes on appreciation that occurs after they inherit it.

For example, if stock purchased for $35,000 is worth $100,000 on the date of death, the heir’s basis becomes $100,000. A sale at that price results in no capital gain. This benefit applies to most capital assets, including real estate, stocks, and business interests, but excludes assets like IRAs and 401(k)s.

The basis can also be “stepped down” if the asset’s value at the time of death is lower than the original purchase price, preventing the heir from claiming a loss the original owner could have. Additionally, the holding period for an inherited asset is automatically considered long-term. This ensures any gain is taxed at the more favorable long-term capital gains rates.

California’s Treatment of Inherited Property Basis

California conforms to the federal stepped-up basis rule for state income tax purposes. However, California’s property ownership rules for married couples interact with this provision, leading to different tax outcomes depending on how an asset is titled.

Community Property

California is a community property state, where assets acquired during a marriage are owned equally by both spouses. When one spouse dies, a “double step-up” rule applies to community property. Both the deceased spouse’s 50% share and the surviving spouse’s 50% share receive a full step-up in basis to the fair market value at the time of death. For example, if a home purchased for $200,000 is worth $2 million when a spouse dies, the survivor’s new basis becomes $2 million.

Separate Property

Separate property includes assets owned before marriage or acquired by gift or inheritance during the marriage. Only the portion of separate property owned by the decedent receives a stepped-up basis. The surviving spouse’s separate property does not receive any basis adjustment, making the characterization of an asset important for tax purposes.

Joint Tenancy

Property held in joint tenancy with right of survivorship passes automatically to the surviving owner, avoiding probate. From a tax perspective, this is less advantageous than community property because only the decedent’s portion of the property receives a step-up in basis. For a married couple, only 50% of the property’s value is stepped up. If a couple’s $2 million home was held in joint tenancy, the survivor’s new basis would be $1.1 million ($1 million for the stepped-up half plus their original $100,000 basis).

The Role of Trusts in Basis Adjustments

How assets are held in a trust influences whether they qualify for a stepped-up basis. The type of trust dictates if the assets are considered part of the decedent’s estate for tax purposes.

Revocable Living Trusts

Assets held in a revocable living trust are eligible for a stepped-up basis. Since the grantor retains control and can revoke the trust, the IRS considers the assets part of the grantor’s taxable estate. Upon the grantor’s death, the assets inside the trust are adjusted to their fair market value. This allows beneficiaries to avoid probate while preserving the tax benefit of the stepped-up basis.

Irrevocable Trusts

The treatment of assets in an irrevocable trust is more complex. When a grantor transfers assets into an irrevocable trust and relinquishes control, the assets are removed from the grantor’s taxable estate. These assets do not receive a stepped-up basis and instead retain the grantor’s original “carryover basis.”

However, some irrevocable trusts are designed to be included in the grantor’s estate to qualify for a basis step-up. IRS Revenue Ruling 2023-2 clarified that for assets to receive a step-up, they must be acquired from a decedent in a way that subjects them to federal estate tax. This ruling has created uncertainty for certain irrevocable trusts that were previously assumed to receive a step-up.

Information Needed to Establish the New Basis

To claim a stepped-up basis, an heir or executor must document the decedent’s date of death and the asset’s fair market value (FMV) on that date. The death certificate officially establishes the date of death. The executor of the estate or successor trustee is responsible for obtaining these valuations.

For real estate, the FMV is established by a formal report from a licensed appraiser. For publicly traded securities, the FMV can be determined using historical price data from brokerage statements. The IRS may request these documents to verify the basis reported on a tax return.

Reporting the Sale of Inherited California Property

Federal Reporting

The sale of an inherited capital asset is reported to the IRS on Form 8949, Sales and Other Dispositions of Capital Assets, and summarized on Schedule D (Form 1040). On Form 8949, the heir lists the asset’s name, sale date, and sales price. In the “date acquired” column, the taxpayer should write “Inherited” to signal that the holding period is long-term.

The cost basis entered is the stepped-up basis, which is the asset’s fair market value on the owner’s date of death. Heirs who receive Form 8971 from an estate’s executor should use a basis consistent with that form.

California Reporting

The process for reporting the sale for California income tax purposes mirrors the federal procedure. The capital gain or loss is carried over from the federal return and reported on California Schedule D. The basis used on the federal return is the same for the state return.