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What Is the Step-Up in Basis?
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The step-up in basis is one of the most valuable tax benefits available to families in California. Think of it as a "reset button" for taxes when someone inherits property. When you inherit assets like real estate, stocks, or other investments, the step-up in basis can potentially save you thousands of dollars in taxes.
Here's how it works in simple terms. When someone passes away, the "basis" of their assets gets "stepped up" to the current fair market value. This means if your parents bought a house for $100,000 years ago, and it's worth $800,000 when they pass away, you inherit it with a basis of $800,000 - not the original $100,000 purchase price.
Why This Matters in California
California's real estate market has seen incredible growth over the decades. Many families have owned homes that have appreciated dramatically in value. Without the step-up in basis, inheriting family property could create massive tax burdens that could force families to sell their ancestral homes just to pay the taxes.
In California, this rule is especially important because property values have increased so much. A modest family home purchased in the 1970s might be worth ten times its original price today. The step-up in basis eliminates the capital gains tax on all that appreciation, which is why many estate planning professionals consider it one of the most powerful wealth preservation tools available to families.
California follows federal tax rules for step-up in basis. This means you get both federal and state tax benefits. Since California has some of the highest state income tax rates in the country, this can represent significant savings. Combined federal and state capital gains rates can exceed 35% for high-income earners in California.
How Basis Works
To understand step-up in basis, you first need to understand what "basis" means. Your basis in property is generally what you paid for it, plus improvements you made over time. This is also called your "cost basis."
When you sell property, you pay capital gains tax on the difference between the sale price and your basis. The lower your basis, the more tax you'll owe. The higher your basis, the less tax you'll pay. It's that simple.
When someone dies, their heirs don't inherit the original basis. Instead, they get a new basis equal to the property's fair market value on the date of death. This is the "stepped-up basis." This rule has been part of the federal tax code since 1954 and has saved American families billions in taxes over the decades.
A Quick Example
Let's say your grandmother bought a house in Los Angeles in 1980 for $80,000. Over the years, she made $20,000 in improvements. Her basis in the house is $100,000.
When she passes away in 2024, the house is worth $1,200,000. You inherit the house with a stepped-up basis of $1,200,000 - not her original $100,000 basis.
If you sell the house right away for $1,200,000, you owe no capital gains tax. Without step-up in basis, you would have owed tax on $1,100,000 of gain. In California, that could mean over $200,000 in combined federal and state taxes. That's a mortgage payment on a nice home!
What Property Qualifies
Most types of property qualify for step-up in basis. This includes real estate, stocks, bonds, mutual funds, and other investments. Business interests and collectibles also typically qualify, though some collectibles have special rules that can be complex.
The key requirement is that the property must be included in the deceased person's estate for tax purposes. Property held in most living trusts qualifies because revocable trusts are considered part of the grantor's estate. Property given away during someone's lifetime does not qualify - this is why many estate planners advise clients to be careful about gifting highly appreciated assets.
In California, community property gets special treatment. When one spouse dies, both halves of community property get stepped up to fair market value. This is more favorable than most other states and represents a significant advantage for California couples.
Community Property Advantage
California is a community property state. This gives married couples a significant advantage with step-up in basis. When one spouse dies, the entire community property gets a step-up in basis, not just the deceased spouse's half.
This means if you and your spouse own a house together as community property, and one of you passes away, the surviving spouse gets a stepped-up basis on the entire house. This can provide enormous tax savings if the surviving spouse later sells the property. Some estate planning attorneys specifically recommend converting separate property to community property for this reason.
To get this benefit, the property must be properly characterized as community property. Working with an estate planning attorney can help ensure your property is titled correctly. Starting your estate plan from scratch with proper property characterization in mind can maximize these tax benefits for your spouse.
Timing Matters
The stepped-up basis is generally based on the fair market value on the date of death. However, executors can sometimes elect to use an "alternate valuation date" six months later if it would result in a lower estate tax. This election must be made consistently for all assets in the estate.
For most California families, estate taxes aren't a concern because of the high federal exemption amount. But the timing still matters for establishing the correct stepped-up basis for income tax purposes. Market volatility around the time of death can sometimes create planning opportunities.
Getting a proper appraisal around the date of death is important. This establishes the stepped-up basis and provides documentation if the IRS ever questions the valuation. Professional appraisals are especially important for real estate, business interests, and other assets that don't have readily available market prices.
Trust Planning and Step-Up in Basis
The relationship between trusts and step-up in basis is nuanced. Revocable trusts generally don't affect step-up in basis - assets in these trusts still get stepped up when the grantor dies. However, irrevocable trusts can complicate matters significantly.
When assets are transferred to certain types of irrevocable trusts, they may lose the ability to receive a step-up in basis at the grantor's death. This is why deciding what assets belong in a trust requires careful consideration of both income tax and estate tax consequences.
Some advanced trust strategies can preserve step-up in basis while still providing estate planning benefits. These strategies often involve grantor trust provisions that cause the trust assets to be included in the grantor's estate for tax purposes. Working with experienced professionals is crucial when implementing these strategies.
Planning Opportunities
Understanding step-up in basis can influence estate planning decisions. For example, it might make sense to hold onto highly appreciated property rather than selling it during your lifetime. This "buy and hold until death" strategy can be particularly effective for real estate in California's appreciating markets.
If you're considering selling property that has gone up significantly in value, it might be worth discussing the timing with your estate planning attorney and tax advisor. Sometimes waiting can save your family substantial taxes. However, you must balance this against other factors like your need for liquidity and the risk that property values could decline.
The step-up in basis also makes gifting strategies more complex. Giving away appreciated property during your lifetime means your heirs lose the potential step-up in basis. This creates a tension between removing assets from your estate and preserving tax benefits for your heirs. Sometimes the answer depends on how long you expect to live and how much further you expect the property to appreciate.
Potential Changes
The step-up in basis has been a stable part of the tax code for many years. However, there have been periodic discussions in Congress about modifying or eliminating this benefit. These discussions often intensify during periods when lawmakers are looking for ways to increase tax revenue.
Any changes would likely only affect very large estates or might include exemptions for modest amounts of property. But it's worth staying informed about potential changes that could affect your family's planning. Some proposals have suggested limiting step-up in basis to a certain dollar amount per person or requiring payment of capital gains tax at death.
Working with professionals who stay current on tax law changes can help ensure your estate plan adapts to any new rules. This is one reason why estate plans should be reviewed regularly rather than created once and forgotten.
Documentation and Records
When you inherit property, keeping good records is crucial. You'll need documentation of the property's fair market value on the date of death to establish your stepped-up basis. This documentation becomes your "proof" if the IRS ever questions your basis calculation.
For real estate, this might mean getting an appraisal. For stocks and bonds, you'll need records of the values on the relevant dates. Your estate planning attorney or tax advisor can help you understand what documentation you need. Don't wait until you're ready to sell to gather this information - it's much easier to obtain values close to the date of death.
These records become important if you later sell the inherited property and need to calculate your capital gains tax. The IRS can challenge basis claims that aren't properly supported by documentation, so keeping good records protects you from unexpected tax bills later.
Working with Professionals
Step-up in basis rules can be complex, especially when dealing with different types of property or family situations. Community property rules, trust structures, and business interests can all affect how step-up in basis applies. Each family's situation is unique, and generic advice may not apply to your specific circumstances.
An experienced estate planning attorney can help you understand how these rules apply to your specific situation. They can also help structure your estate plan to maximize the benefits for your family. Talking to your family about estate planning early can help ensure everyone understands the tax implications of inheriting family property.
Tax advisors and CPAs can provide additional guidance on the income tax implications and help with the documentation needed to support stepped-up basis claims. The cost of professional advice is usually a fraction of the taxes you can save through proper planning.
The Bottom Line
Step-up in basis is one of the most valuable tax benefits available to California families. It can eliminate capital gains taxes on decades of property appreciation, potentially saving tens or hundreds of thousands of dollars. For some families, it can literally save more in taxes than most people earn in a year.
Understanding how this rule works can help you make better decisions about your property and estate planning. While the concept might seem technical, the financial impact on your family can be enormous. The difference between understanding and ignoring step-up in basis can be the difference between preserving wealth for your children and watching it disappear to taxes.
If you own property that has appreciated significantly in value, it's worth discussing step-up in basis with your estate planning team. Proper planning can help ensure your family gets the maximum benefit from this important tax rule. The peace of mind that comes from knowing your family won't face crushing tax bills when they inherit your property is invaluable.
