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"What Happens to Your Home After Death in California: Taxes, Capital Gains, and the Step-Up in Basis Explained"

Posted by James Burns | Oct 10, 2024 | 0 Comments

What Happens to Your Home When You Die in California?

When someone passes away, many families face a pivotal question: what happens to the family home? Whether you're thinking about leaving your house to your loved ones or preparing your estate plan, it's essential to understand how the transfer of real property works in California, especially from a tax perspective. Knowing how your home will be treated for estate taxes, capital gains taxes, and the step-up in basis can significantly impact your heirs and surviving spouse.

In this blog, we'll cover how homes are taxed after death in a community property state like California, the relevant laws involved, and what your family can expect when the time comes.

1. Community Property and the Step-Up in Basis

California is a community property state, which means that any property acquired during marriage is generally considered to belong equally to both spouses. When one spouse dies, the surviving spouse receives a full step-up in basis on the entire property, not just the half that belonged to the deceased.

So, what does this "step-up" mean?

The basis of an asset is its original cost for tax purposes. The "step-up" increases the property's basis to its fair market value (FMV) at the time of the decedent's death. For tax purposes, this step-up can eliminate much of the capital gains liability if the property is later sold.

Let's look at an example.

Example:
John and Mary bought their home 30 years ago for $200,000. At the time of John's death, the home is worth $1,000,000. Because California is a community property state, Mary receives a stepped-up basis on both halves of the property. So, if Mary sells the home for $1,050,000, her capital gains tax liability will only be on the $50,000 gain (the difference between the selling price and the stepped-up basis).

This step-up is a significant tax advantage that can prevent your family from being hit with a huge capital gains tax bill.

2. Capital Gains and Estate Taxes

When a home is inherited, the sale of the property is subject to capital gains taxes. However, thanks to the step-up in basis, heirs are often shielded from large capital gains taxes, provided the sale happens shortly after death.

For instance, if your heirs inherit a home worth $1,000,000 and sell it for the same amount, there would be no capital gains tax because the step-up in basis makes the sale price and the basis the same.

In addition to capital gains tax, there's also the matter of estate taxes. For most people, estate taxes are not an issue because, in 2024, the federal estate tax exemption is $13.61 million per individual (IRC § 2010). If your estate is valued below this threshold, no federal estate tax will be owed.

California does not impose a state-level estate or inheritance tax, which is good news for families who inherit property in the state.

3. Depreciation Recapture

What happens if the deceased rented out the home or used part of it for business purposes, like a home office? Normally, depreciation recapture would require paying taxes on any depreciation deductions claimed during ownership. However, if the owner passes away, this depreciation recapture is wiped out due to the step-up in basis.

Example:
If John and Mary had rented out their property for years and claimed $100,000 in depreciation, this would normally be recaptured as taxable income if they sold the property. But when John dies, and the property gets a step-up in basis, that depreciation disappears, and Mary (or her heirs) won't have to pay taxes on it.

This is a powerful benefit that can save thousands of dollars in taxes.

4. Proposition 19 and Property Taxes for Heirs

In California, Proposition 19 (effective February 2021) significantly changed how inherited properties are taxed. Before Prop 19, children inheriting a home from their parents could keep the same low property tax rate even if they didn't live in the home. Now, under the new rules, children can only retain the parent's low property tax rate if they use the home as their primary residence.

If the inherited property is used as a rental or second home, the property will be reassessed at the current market value, likely increasing the annual property taxes substantially.

Example:
If John and Mary's home was taxed based on its original value of $200,000, the annual property tax might be $2,000 (based on 1% of assessed value under Proposition 13). If their children inherit the home and don't live in it, the home will be reassessed at $1,000,000, and the new property taxes could be around $10,000 per year.

This is a crucial consideration for those planning to pass their property to heirs in California.

5. What About Upgrades and Improvements?

What happens to improvements made to the home during the owner's lifetime? Generally, upgrades like a new kitchen or bathroom increase the property's basis. However, after death, the home's step-up in basis to fair market value supersedes any previous improvements, effectively resetting the basis.

This means that any past improvements won't factor into capital gains calculations after the owner's death because the home is appraised at its current value.


Call to Action

Estate planning in California comes with unique opportunities and challenges, especially when it comes to your home. Whether you're looking to minimize capital gains taxes, protect your family from increased property taxes under Proposition 19, or simply ensure your estate is handled smoothly, having a plan in place is critical.

At the Law Office of James Burns, we have over 24 years of experience helping families navigate the complexities of estate planning. We can guide you through the intricacies of community property laws, step-up in basis, and Proposition 19 to ensure your home is protected and your heirs avoid unnecessary taxes.

Contact us today at (949) 305-8642 or visit our website at www.jamesburnslaw.com to schedule a consultation. Let's plan today so your loved ones are taken care of tomorrow.

About the Author

James Burns

James Burns, Esq. is a seasoned attorney specializing in estate planning, asset protection, and tax law. Known for his expertise in Private Placement Life Insurance (PPLI), James helps high-net-worth individuals protect their wealth and achieve tax efficiency, including pre-immigration planning. With over 20 years of legal experience, he offers tailored solutions for estate planning and corporate transactions. James is also a published author and sought-after speaker, recognized for his deep knowledge and strategic approach to wealth preservation.

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