In high-cost markets like Orange County, California, clients often own real estate or investment portfolios with substantial unrealized gains. One of the most overlooked yet powerful tax strategies available at death is the step-up in basis. This guide unpacks the mechanics of how basis adjustments work under IRC §1014, how they interact with California trust law and property tax rules, and why revocable living trusts remain essential in executing a clean, tax-efficient transfer.

We'll also cover how sophisticated strategies like structured installment sales under IRC §453 and Private Placement Life Insurance (PPLI) can support long-term deferral, asset protection, and legacy goals. This is an essential briefing for trustees, real estate owners, tax professionals, and fiduciaries who want to navigate California estate planning with precision.

What Is a Step-Up in Basis?

The 'basis' of an asset is generally its original cost. When a person passes away, IRC §1014 allows their heirs to receive an adjusted basis—stepped up to the fair market value (FMV) as of the date of death. This applies to most capital assets: real estate, stock, business interests, and even collectibles.

This provision wipes out unrealized capital gains that accrued during the decedent's lifetime. If the heirs sell the asset shortly after inheriting it, there may be little or no capital gain to report.

Trust vs. Probate – Legal Application in California

Although the step-up occurs whether or not a trust exists, a revocable living trust significantly improves the administrative efficiency of the estate. Probate in California can take 12–18 months, during which time heirs may be unable to sell or refinance a property.

When assets are held in a properly funded trust, the successor trustee can immediately retitle and distribute those assets. This ensures the fair market value at death is well-documented, typically with a certified appraisal, and can be used as the new basis.

California-Specific Considerations: Proposition 13 and 19

Proposition 13 limits property tax reassessments, but Proposition 19, passed in 2020, altered how parent-child exclusions apply. Effective February 16, 2021, the Prop 58 exclusion was replaced, limiting transfers to those where the child uses the home as a primary residence and capping the exempted value.

While a trust won't avoid reassessment on its own, a well-drafted trust that qualifies for Prop 19 exclusions and incorporates timely filing of the BOE-19-P form can help preserve both property tax and capital gain benefits.

Case Example: Newport Coast Residence

A client purchased a Newport Coast home in 1995 for $900,000. At death in 2025, it's valued at $4.8 million. The heirs want to sell the property. Without a step-up, the capital gain would be $3.9 million. But under §1014, the basis resets to $4.8 million. A sale shortly thereafter results in zero taxable gain (minus transaction costs).

Contrast this with a property transferred by lifetime gift. The recipient takes the original basis—and may face millions in capital gains. This is why estate planning often recommends inheritance over gifting appreciated assets during life.

Community Property vs. Joint Tenancy

In community property states like California, assets held as community property receive a full step-up in basis for both halves. In contrast, joint tenancy property only steps up the deceased spouse's share. This can cause unintended tax consequences if not addressed through titling and trust design.

Best practice: Convert joint tenancy to community property with right of survivorship and place it into a revocable trust to preserve both step-up and estate efficiency.

Structured Installment Sales: Preserve Liquidity, Defer Gains

If heirs want liquidity but prefer to spread out their tax liability, a structured installment sale under IRC §453 offers a powerful tool. It allows the property to be sold over time, deferring capital gains taxation and converting illiquid real estate into predictable cash flow.

This strategy is especially helpful when combined with stepped-up basis, as any gain recognized is limited to post-death appreciation, further reducing tax exposure.

PPLI: Combining Tax Deferral with Wealth Transfer

Private Placement Life Insurance allows ultra-high-net-worth individuals to grow investments tax-deferred within a policy wrapper. Assets within a PPLI policy avoid annual taxation, and death proceeds pass to heirs income-tax free. PPLI can be integrated into irrevocable trusts or dynasty trusts to leverage both step-up planning and long-term legacy protection.

Relevant Statutes and Legal Authority

- Internal Revenue Code §1014 – Step-up in basis at death
- Internal Revenue Code §453 – Installment method
- IRC §2040(b) – Community property rules
- California Revenue & Taxation Code §63.1 – Prop 19 transfer exclusion
- California Probate Code §13050 – Definition of probate property
- IRS Publication 551 – Basis of Assets

Frequently Asked Questions (FAQ)

Q: Does the step-up in basis apply automatically?
A: Yes, under federal law. But proving fair market value and clean title is easier when the asset is held in trust.

Q: What kinds of assets qualify for the step-up?
A: Real estate, stocks, mutual funds, business interests, and other capital assets generally qualify.

Q: Can I get a step-up in basis during my lifetime?
A: No. Basis step-up occurs only at death. Gifting appreciated assets during life transfers the original basis.

Q: How do structured installment sales help heirs?
A: They allow beneficiaries to control when gains are realized and spread tax liability across years.

Q: Can PPLI be used for tax-free inheritance?
A: Yes. PPLI allows tax-free growth and distribution when held in a properly structured trust.

Legal Mechanics of IRC §1014: Why This Rule Matters

IRC §1014 is foundational to post-death tax planning. It establishes that the basis of property acquired from a decedent is the fair market value (FMV) at the date of the decedent's death (or alternative valuation date). This provision prevents heirs from paying capital gains tax on appreciation that occurred during the decedent's lifetime. It's critical to understand that this rule applies broadly to real property, tangible personal property, and intangible capital assets—making it a universal consideration in estate planning.

Appraisals and IRS Form 8971: Documenting the Step-Up

To take advantage of the step-up, proper documentation is key. The IRS requires estate executors to file Form 8971 to report the FMV of inherited assets for large estates subject to filing. Even for estates below the federal threshold, obtaining qualified appraisals and maintaining valuation records is critical in case of audit. The burden of proof lies with the taxpayer. Trust-based plans should include clear instructions to obtain and store appraisals in the trustee's recordkeeping process.

Case Study: Inherited Stock Portfolio

A decedent leaves behind a portfolio of tech stocks purchased in the early 2000s for $200,000. By the date of death, the value is $1.4 million. The beneficiary sells the portfolio a month later for $1.42 million. Due to the step-up in basis, only the $20,000 post-death appreciation is subject to capital gains tax. If instead the stocks had been gifted during the decedent's lifetime, the original $200,000 basis would transfer, and the entire $1.22 million gain would be taxable. This underscores the importance of inheritance timing.

Case Study: Privately Held Business Interest

A family business owner dies, leaving a 100% LLC interest to her children via a revocable trust. The business was initially formed with $50,000 and is now valued at $2 million. The trust ensures a smooth succession, and the basis in the LLC is stepped up to $2 million. When the children sell their interests two years later for $2.3 million, only $300,000 is subject to capital gains tax. Had the interest been transferred during life, they would have owed tax on $2.25 million.

Expanded PPLI Strategy Example

A high-net-worth individual in Newport Beach funds a South Dakota Dynasty Trust with $5 million in cash and uses it to purchase a Bermuda-based PPLI policy. The investments inside grow tax-deferred. Upon death, the trust receives $12 million tax-free. Because the policy was held in trust and funded via gift strategies, it avoids estate tax inclusion. PPLI thus complements the step-up rule by removing future appreciation from the estate altogether.

Blended Strategy: Structured Installment Sale + PPLI

An heir inherits a commercial property worth $3 million with a stepped-up basis. Instead of selling outright, they use a structured installment sale under IRC §453, receiving $300,000 per year for 10 years. They then place those proceeds into a PPLI policy, allowing each year's installment to grow tax-deferred. This strategy creates liquidity, tax control, and wealth transfer efficiency—stacking the advantages of §1014, §453, and PPLI.

More Frequently Asked Questions

Q: Can the IRS challenge a step-up in basis?
A: Yes, if the FMV is unsupported or undervalued. That's why a qualified appraisal and strong documentation are essential.

Q: What if the asset is held in an LLC or partnership?
A: The interest in the entity may receive a step-up, but not the underlying assets unless it's a disregarded entity. Tax and legal counsel should evaluate this closely.

Q: Does the step-up apply to retirement accounts?
A: No. IRAs, 401(k)s, and other qualified accounts are not eligible for a step-up in basis—they remain fully taxable as ordinary income to heirs.

Take the Next Step – Schedule a Strategic Review

If you're concerned about capital gains, Prop 19, or estate tax exposure, now is the time to review your plan. Our firm has helped over 6,000 clients in Orange County design and implement estate planning strategies that protect legacy assets. From revocable living trusts to advanced tax planning tools like structured sales and PPLI, we offer white-glove service to California's affluent families.

Disclaimer

This material is for informational purposes only and is not legal, tax, or investment advice. Each situation is unique. Consult your attorney, CPA, or financial advisor for personalized advice.

Intellectual Property Notice

© 2025 Law Office of James Burns. All rights reserved. This material may not be copied, redistributed, or used commercially without express written consent. James Burns, Esq., is a licensed California attorney specializing in estate planning, tax strategy, and legacy wealth solutions.