Although the real estate market has fluctuated over the past few years, over time real estate has appreciated significantly. The median price of a home in California in 1968 was less than $25,000. Today, the median price of a home in California is over $450,000. Typically, if you were to sell a house that has appreciated significantly, you would likely owe considerable capital gains tax. In general, capital gains tax is a tax on the difference between the original purchase price (the “basis”) and the sales price on real property and securities. There are some exceptions to the general rule such as the cost of improvements increasing the basis and a $250,000 exclusion from capital gains tax on the sale of a principal residence pursuant to Section 121 of the Internal Revenue Code. Nevertheless, if you bought a home in California in 1968 and sold it today, you would likely owe significant capital gains tax.
As indicated above, if you bought a home in 1968 for $25,000 and sold it today for $450,000, not taking into account adjustments to basis for home improvement and the Section 121 exclusion, you would owe capital gains tax on the $425,000 difference. Instead of selling the house, if you were to give away a house that you purchased for $25,000 when it was worth $450,000, your $25,000 basis would “carry-over” to the recipient of your gift. If the recipient sold the house for $450,000, the recipient would owe capital gains tax on the $425,000 difference.
Step-Up in Basis
Suppose instead of gifting the house away during your lifetime, you left the house to your beneficiary upon your death through your will or your trust. Even though your basis in the house was $25,000, your beneficiary would not inherit your basis. Instead, your beneficiary’s basis would be adjusted to the fair market value on the date of death. If the house were worth $450,000 at the time of your death, your beneficiary’s basis would be adjusted to $450,000. If your beneficiary sold the house for $450,000, your beneficiary would not have to pay any capital gains tax at all. If your beneficiary waited 10 years to sell the house and the value had appreciated to $600,000, your beneficiary would only have to pay capital gains tax on the $150,000 of appreciation between the value on your date of death and the sales price.
This adjustment to a beneficiary’s basis after a transfer upon death to the fair market value as of the date of the transferor’s death is commonly referred to as a “step-up” in basis. It should be noted that the basis adjustment could be a “step-down” in basis if the real property were worth less at the date of death than the original purchase price. However, with regard to real property, particularly in California, over a long period of time, it is generally likely that real estate values will increase.
Half Step-Up in Basis
Suppose that you own the house with your spouse equally as joint tenants. If your spouse pre-deceases you, your spouse’s half of the house will get a “step-up” in basis as to the fair market value on the date of his/her death. However, your half of the house will not get a “step-up” in basis because you are still living. Therefore, if you were to sell the house, you would be able to eliminate or substantially reduce the capital gains tax on your spouse’s half of the house, but would have to recognize significant gain on your half of the house.
This concept whereby the deceased spouse’s half of the house gets a “step-up” in basis whereas the surviving spouse’s half does not get a “step-up” in basis is often referred to has a “half step-up” or a “single step-up” in basis. Although the surviving spouse’s capital gains tax would be reduced to an extent, the surviving spouse still has to recognize capital gains tax on his/her half of the house.
Full Step-Up in Basis
Suppose that you own the house with your spouse equally, but instead of holding it as “joint tenants,” you hold it as “community property.” California is one of ten states that recognize community property as a method for holding title to property between spouses.
If the house is held as “community property” and your spouse pre-deceases you, just as in the example above, your spouse’s half of the house will get a “step-up” in basis as to the fair market value on the date of his/her death. However, this time, your half will also get a “step-up” in basis as to the fair market value as of your spouse’s date of death. If you decide to sell the house, you would be able to eliminate or dramatically reduce the capital gains tax on the entire house.
This concept is often referred to as a “full step-up” or a “double step-up” in basis. Knowing these rules, spouses in community property states will often change title from joint tenants or from an alternate form of ownership to community property in order to double this tax break, potentially saving tens of thousands of dollars. It is important to note that property may be held as community property even though it is placed in a living trust.
As with most aspects of the law, issues are not always as simple as they appear to be on the surface. All forms of joint ownership have their pros and cons and you should consult a qualified advisor before changing the form of ownership on property.
KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California, and Kyle may be reached at 831-920-0205831-920-0205.
Disclaimer: This article is for general information only. Reading this article does not establish an attorney-client relationship. Before acting on any of the information presented in this article, you should consult a competent attorney who is licensed to practice law in your community.