Most California families owe far less capital gains tax than they expect.
If you've recently inherited your parents' home, you're probably wondering how much you'll owe in taxes when you sell it.
Many people assume the IRS taxes the entire sale price. Others believe inheriting a home is itself a taxable event. Neither is true.
In fact, most California families who inherit a home owe little or no capital gains tax when they sell. The reason is a tax rule called the step-up in basis, which often eliminates the appreciation that occurred during the deceased owner's lifetime.
To understand why, you only need to understand one simple formula.
Capital gains tax is not calculated using the home's sale price.
Instead, the formula is:
Capital Gain = Net Sale Proceeds − Adjusted Basis
Your net sale proceeds are the amount you actually receive after paying the costs of selling the property, such as:
Your basis is the property's tax value. It represents your investment in the property for income tax purposes and is the number the IRS uses to determine your taxable profit.
Most of the time, the amount of capital gains tax you owe has very little to do with what the house sells for. Instead, it depends on one question:
What is your basis?
Once you understand how basis works, the rest of the tax calculation becomes surprisingly straightforward. The same formula governs the sale of a home you own and live in, though the exclusion rules available to you there don't apply to inherited property.
Before we go further, let's clear up one of the biggest misconceptions about inherited property.
You do not owe capital gains tax simply because you inherited a house.
Inheriting real estate is not a taxable capital gains event. Capital gains tax is triggered when you sell the property.
Think of basis as the property's tax starting point.
For most homeowners, basis begins with what they originally paid for the property.
Suppose your parents bought a California home in 1988 for $210,000. Their original basis was $210,000.
Over the years, that number may increase or decrease.
Money spent improving the property generally increases basis.
Examples include:
These improvements become part of the home's tax investment and increase basis dollar for dollar.
Routine maintenance keeps a house in good condition but generally does not increase basis.
Examples include:
Although these expenses may increase the home's value in a practical sense, they usually do not affect the property's tax basis.
If the property was ever used as a rental, depreciation deductions claimed over the years generally reduce basis.
After accounting for improvements and depreciation, you arrive at the property's adjusted basis.
That adjusted basis is the number used to calculate your capital gain.
Suppose a home sells for $1.4 million.
After paying commissions and closing costs, the seller receives $1,323,000 in net sale proceeds.
Now imagine two different people selling the exact same house.
The first person's adjusted basis is $300,000.
Their taxable capital gain is:
$1,323,000 − $300,000 = $1,023,000
The second person's adjusted basis is $1.3 million.
Their taxable capital gain is only:
$1,323,000 − $1,300,000 = $23,000
Nothing about the sale changed.
The home sold for the same price.
The closing costs were identical.
The only difference was the owner's basis.
So the obvious question becomes:
How can two people selling the same house have completely different tax bases?
The answer depends on how they acquired the property.
If they received the house as a gift during their parents' lifetime, they usually receive a carryover basis.
If they inherited the home after their parents passed away, they usually receive a step-up in basis.
That distinction determines whether the tax bill is a few thousand dollars or several hundred thousand dollars.
The biggest factor affecting your capital gains tax isn't the home's value or even its sale price. It's how you acquired the property.
Did your parents give you the house while they were still alive? Or did you inherit it after they passed away?
The answer determines your tax basis.
When parents transfer a home to their children during their lifetime, the child generally receives a carryover basis.
A carryover basis means exactly what it sounds like. The parents' basis carries over to the child.
For example, suppose your parents bought their home decades ago for $210,000. Over the years, they made $90,000 in capital improvements, bringing their adjusted basis to $300,000.
If they sign a deed transferring the property to you during their lifetime, your basis is generally $300,000. You step into your parents' shoes for tax purposes.
When you eventually sell the home, you'll pay capital gains tax on the appreciation that occurred while your parents owned it, in addition to any appreciation that occurred after you received it.
This is the hidden cost of the deed-signing shortcut. Parents who add a child to title, or sign the house over outright to avoid probate, are often trading a modest living trust estate plan savings for a very large income tax bill.
The rules are very different when you inherit property after the owner's death.
Under Internal Revenue Code Section 1014, inherited property generally receives a step-up in basis equal to its fair market value on the date of death.
Instead of inheriting your parents' tax history, you start over with a new basis based on what the property was worth when they died.
Suppose the home was worth $1.3 million on your mother's date of death.
Your basis is generally $1.3 million.
If you later sell the property for $1.4 million and receive net sale proceeds of $1,323,000 after paying selling costs, your taxable capital gain is only:
$1,323,000 − $1,300,000 = $23,000
Compare that to the lifetime gift example.
The house sold for the same amount.
The closing costs were the same.
The only difference was the basis.
Here's the comparison side by side.
|
Lifetime Gift |
Inheritance |
|
Adjusted Basis: $300,000 |
Adjusted Basis: $1,300,000 |
|
Net Sale Proceeds: $1,323,000 |
Net Sale Proceeds: $1,323,000 |
|
Taxable Gain: $1,023,000 |
Taxable Gain: $23,000 |
The difference isn't subtle.
Receiving the home as a lifetime gift may expose you to capital gains tax on decades of appreciation.
Inheriting the home generally wipes away that appreciation by resetting the basis to the property's fair market value on the date of death.
That's why most inherited home sales result in little or no capital gains tax.
Many people are surprised by the step-up in basis rule.
The idea behind it is straightforward.
When someone dies, the tax law generally resets the property's basis to its fair market value on the date of death. As a result, appreciation that occurred during the deceased owner's lifetime is generally not taxed as capital gain when the heirs sell the property.
That doesn't mean the property is permanently tax-free.
If the home continues to increase in value after the owner's death, that new appreciation may be subject to capital gains tax when the property is eventually sold.
In other words, the step-up in basis erases the gain that accumulated before death, but it does not eliminate gain that occurs after death.
The step-up in basis is a federal tax rule that applies nationwide. California, however, provides an additional advantage for many married homeowners because it is a community property state.
If your parents were married and owned their home as community property, California law provides an additional tax advantage that many families don't realize exists.
Under federal tax law, property generally receives a step-up in basis when someone dies. But because California is a community property state, both halves of a community property asset generally receive a new basis when the first spouse dies, not just the deceased spouse's half.
Here's an example.
Suppose your parents bought their home many years ago for $200,000. By the time your father passes away, the home is worth $1.2 million.
Because the home is community property, your mother's basis in the entire property generally steps up to $1.2 million, even though she already owned one-half of the home.
If she sells the home shortly after your father's death for approximately its date-of-death value, she may owe little or no capital gains tax.
If she keeps the home until her own death, the property generally receives another step-up in basis to its fair market value on her date of death.
As a result, children often inherit the home with a basis equal to its current market value, allowing them to sell it with little or no capital gains tax if the sale occurs soon after the inheritance.
This "double step-up" is one of the reasons so many California families are surprised to learn they owe far less tax than they expected.
It is also a benefit you can lose by doing nothing. The first step-up has to be documented when the first spouse dies, which is one of several reasons the work that follows a spouse's death matters years later. Families who skip that step often find, decades on, that nobody can prove what the house was worth in the year the first parent died, so they have to get a retrospective appraisal, which often cost more than a real time appraisal and may not be as accurate.
There is one common exception to the general rule.
Many estate plans created during the 1990s and early 2000s include what are commonly called AB Trusts, ABC Trusts, or bypass trusts.
These trusts were designed when the federal estate tax exemption was much lower than it is today. Their primary purpose was to reduce estate taxes for wealthy families.
While they often accomplished that goal, some of these trusts can produce an unintended income tax consequence today.
When the first spouse dies, the trust may divide the couple's assets into separate shares. Assets placed into the bypass trust generally do not become part of the surviving spouse's taxable estate when the surviving spouse later dies.
Because of that, those assets may not receive a second step-up in basis.
The result is that children may inherit property using the value established at the first parent's death rather than the value at the second parent's death.
If the property appreciated substantially during those years, the children could inherit a much lower basis than expected and face a significant capital gains tax when they eventually sell.
Fortunately, not every trust has this problem.
Many modern estate plans avoid mandatory bypass trust provisions altogether, and an older bypass trust can often be unwound or modified depending on how it was drafted and whether the surviving spouse is still living. The window for fixing it closes at the second death, which is usually the moment the family discovers the problem exists.
The important point is this:
Never assume an inherited home's basis without reviewing the trust that owns it.
A brief review before listing the property can prevent an expensive surprise later.
A step-up in basis does not permanently eliminate capital gains tax.
Instead, it resets your basis to the property's fair market value on the date of death.
Any appreciation after that date is generally taxable when you sell.
Here's an example.
|
Event |
Value |
|
Fair market value on date of death |
$1,200,000 |
|
Net sale proceeds two years later |
$1,320,000 |
|
Taxable capital gain |
$120,000 |
Notice what happened.
The appreciation that occurred during your parent's lifetime is generally not taxed because of the step-up in basis.
However, the $120,000 increase that occurred after your parent's death is still subject to the normal capital gains rules.
For that reason, many beneficiaries choose to sell inherited property relatively soon after completing the trust administration process, while others decide the investment potential of keeping the home outweighs the future tax consequences.
Neither approach is automatically right or wrong. The decision depends on your family's financial goals, the condition of the property, the local real estate market, and the potential tax consequences.
If you inherit a home, one of the most important things you can do is obtain a professional appraisal establishing the property's fair market value on the date of death.
That appraisal is more than just a real estate opinion. It is evidence supporting your stepped-up basis if the IRS or the California Franchise Tax Board ever questions your tax return.
Many families assume they can rely on a realtor comp appraisal, a Zillow estimate or another online valuation tool. While those estimates may be useful for getting a general sense of value, they are not a substitute for a professional appraisal prepared by a licensed appraiser.
The best time to obtain the appraisal is as close to the date of death as possible. Waiting several years often means paying for a retrospective appraisal, which is typically more expensive and may be more difficult to prepare accurately.
A relatively small appraisal fee today can save substantial time, expense, and uncertainty if your basis is ever challenged years later. It belongs on the short list of things a successor trustee should handle in the first few months after a death, alongside notifying beneficiaries and inventorying the trust's assets.
Capital gains tax and California property taxes are completely different issues.
A step-up in basis may significantly reduce, or even eliminate, your capital gains tax when you sell an inherited home.
That does not mean the property will keep its existing property tax assessment.
Whether the property is reassessed depends on California's Proposition 19 and whether you qualify for one of its exclusions.
Because the rules governing property taxes are entirely separate from the rules governing capital gains tax, it's important to analyze each issue independently. It is common to owe almost nothing in capital gains tax on an inherited home while watching the annual property tax bill triple.
The analysis gets harder when more than one child inherits the house, because the parent-child exclusion depends on someone actually moving in and claiming it as a primary residence. Siblings who plan to sell rarely qualify.
If you remember only one thing from this article, remember this:
Capital Gain = Net Sale Proceeds − Adjusted Basis
Most families focus on what the house will sell for. The IRS focuses on your basis.
If you inherited a California home, your basis generally steps up to the property's fair market value on the date of death. That one rule often eliminates decades of appreciation for income tax purposes, which is why many inherited homes can be sold with little or no capital gains tax.
Before you sell, however, make sure you understand:
A little planning before you list the property can save thousands, or even hundreds of thousands, of dollars in unnecessary taxes.
No. Simply inheriting a house does not trigger capital gains tax. Capital gains tax is generally due only when you sell the property. If you inherit the home, you also usually receive a step-up in basis equal to the property's fair market value on the date of death, which often significantly reduces the taxable gain.
A carryover basis generally applies when property is given to you during the owner's lifetime. You receive the owner's existing adjusted basis.
A step-up in basis generally applies when you inherit property after death. Instead of receiving the owner's historical basis, your basis is reset to the property's fair market value on the date of death.
That difference can reduce your taxable gain by hundreds of thousands of dollars.
The calculation is straightforward:
Capital Gain = Net Sale Proceeds − Adjusted Basis
Your net sale proceeds are the amount you receive after deducting selling costs, such as real estate commissions, escrow fees, title charges, and transfer taxes.
Your adjusted basis depends on how you acquired the property and whether you received a carryover basis or a stepped-up basis.
California does not have a special capital gains tax rate. Instead, capital gains are taxed as ordinary income for California income tax purposes.
Depending on your circumstances, you may also owe federal capital gains tax and, in some cases, the federal Net Investment Income Tax.
The step-up in basis generally eliminates tax on appreciation that occurred during your parent's lifetime.
Any appreciation that occurs after the date of death may still be subject to capital gains tax when you sell the property.
Yes.
A professional appraisal establishes the property's fair market value on the date of death, which generally becomes your stepped-up basis.
Without credible documentation, proving your basis during an IRS or California Franchise Tax Board audit can be much more difficult.
If your parents transferred the home to you during their lifetime, you generally receive a carryover basis rather than a stepped-up basis.
That means you inherit their adjusted basis and may owe capital gains tax on appreciation that occurred while they owned the property.
Yes.
Some older estate plans containing bypass trusts, often called AB Trusts or ABC Trusts, can prevent part of the property from receiving a second step-up in basis when the surviving spouse dies.
If the home is owned by a trust, it is worth having the trust reviewed before selling the property.
No.
Proposition 19 governs California property tax reassessment. It does not determine your capital gains tax.
A homeowner may owe little or no capital gains tax because of a step-up in basis while still experiencing a substantial increase in annual property taxes because of reassessment.
If the property has appreciated significantly or is owned by a trust, the answer is usually yes.
Reviewing the trust, title, and tax basis before listing the property can help you avoid costly surprises and ensure you understand the tax consequences before the sale closes.
Most of the expensive mistakes we see with inherited homes are not made at the closing. They are made months earlier, by families who assumed the tax answer was obvious and found out otherwise after the sale had already closed.
The three questions to consier before you sign a listing agreement are the ones this article started with. How did you acquire the property. Does a trust own it, and if so, what does that trust say about basis. And can you prove the date-of-death value.
If the home is held in a trust, or if your parents' estate plan was written before 2013, those questions are worth a few hours for an attorney to review and consider the issue. Worth the investment and cheaper than an amended return and a six-figure tax bill later.
We have been handling California estate planning and trust administration since 1996, with flat fees published up front and an attorney, not a paralegal or caseworker, as your point of contact from start to finish. We work with families across California, in person from our El Dorado Hills, Roseville, San Luis Obispo, and San Diego offices or virtually from wherever you are.
If you are preparing to sell an inherited home, get in touch before you make a decision you cannot undo. (800) 394-1988.