Capital Gains Tax and Property Tax Transfer on Inherited Assets
Below is a recap, for informational purposes only, of the most common situations involving capital gain and property tax computations on inherited real estate properties.
1. Capital Gains Tax on Inherited properties
As an heir, you may have questions about the tax consequences of inheriting a real estate property. Beneficiaries generally do not have to pay income tax on property they inherit – with the common exception of money withdrawn from an inherited retirement account (IRA or 401(k) plan). But if you inherit an asset and later sell it, you may realize a taxable capital gain.
1-1. Tax Basis
To understand capital gains tax, you must understand the
concept of tax basis. The "tax basis" of an asset is the value that’s
used to calculate the taxable gain or loss when the asset is sold.
Usually, the tax basis is the price the owner paid for the
asset. For example, if you bought a house for $100,000, your tax basis would be
$100,000. If you sold it a month later for $120,000, your taxable gain would be
1-2. What is your tax basis when you don’t buy
something, but inherit it?
The tax law says that your tax basis is generally the value
as of the previous owner’s date of death and includable in the previous owner's tax estate. For example, if a son inherits a
house from his mother that’s worth $200,000 as of her death, his tax basis is
$200,000. It doesn’t matter that the deceased mother's tax basis was only
$75,000, the amount she paid for the house 30 years ago.
The inheritor’s tax basis is also known as the "fresh
start basis" because the basis is recalculated from the previous owner’s
purchase price to the date-of-death value. If the property is held for a long
time, its value generally goes up.
That said, the basis could be reduced, too, if the property
was worth less when the person died than it was when it was bought. What
matters is the date-of-death market value.
Be aware that for very large estates if the estate owes
estate tax, the basis may be figured differently. Instead of the date of death
value, the executor can elect an alternative valuation date of six months after
1-3. Capital Gains Tax
When someone sells an inherited asset, capital gains tax
will be due on the difference between the sales price and the tax basis. The
higher the basis, the smaller the difference between it and the sales price.
When an inherited asset is sold the proceeds of the sale are always treated as
a long-term capital gain or loss, regardless of how long the asset was owned by
the original owner or the heir.
For example, take a house inherited by a son from his mother
with a date-of-death value of $200,000. If the son promptly sells it for
$200,000, no tax will be owed, because he gets a fresh start tax basis of
$200,000. But if his tax basis had been the same as his mother’s, $75,000, then
he would have owed capital gains tax on his gain of $125,000 on the same
1-4. Jointly Owned Property
Tax basis gets a little more complicated when a property is
co-owned and one of the owners dies. It’s a common situation, of course,
because many couples own valuable properties together and leave their shares to
each other. There are also situations where unmarried family members own
property as joint tenants, such as when siblings inherit a portion of a
parent’s home, or sometimes a parent might gift part of his/her right to their residence
to a child to avoid probate.
1-5. Joint tenancy property
When a property is held by two owners in joint tenancy
generally only half of it gets a fresh start tax basis when the first owner dies.
For example, say a couple owns a house worth $200,000; they paid $150,000 for
it. If one of the owners dies, the survivor gets a fresh start tax basis for
the half he or she inherits. The survivor already owned a half-interest, so for
this portion, his/her basis stays the same. As a result, the new basis for the
survivor is $175,000. i.e. his/her basis in the original half-interest is still
$75,000 plus the basis of the inherited half-interest for $100,000.
1- 6. Community property
In community property states such as California married
couples get a tax advantage. Both halves of the community property (owned by
the couple together) get a fresh start tax basis when one spouse dies and the
other becomes sole owner because each spouse legally owns 100% of all community
property rather than each of them owning 50%. Therefore, using the same numbers described in
the example above, the surviving spouse would have a new fresh start tax basis
of $200,000 after the first spouse dies.
1.7. Gifted property
When a gift is made the recipient’s basis generally is what
the giftor’s basis was prior to the gift. There is a weird quirk however- if it
is sold at a gain then the giftor’s basis is used, but if sold at a loss the
basis to calculate this loss is the lesser of the giftor’s basis or the fair
market value of the gift at the time of transfer. This minimizes the capital
loss that can result from the sale of a gifted property and prevents taxpayers
from shifting an asset with an unrealized loss to someone else to offset an
otherwise taxable capital gain.
2. Property Tax Reassessment on Inherited Properties: Proposition 19
The Impact of Proposition 19 voted on November 3, 2020, is twofold: 1.) it modifies the rules pertaining to the transfer of property tax amount of real estate properties between parents and children (and under some circumstances to their grandchildren), and 2.) it provides property tax relief to a select group of people.
2-1. Proposition 19 and Property Tax Transfers
Under the former property tax
law, parents could transfer to their children (and under some circumstances to
their grandchildren) their primary residence, worth any amount, AND a property
worth $1 million of assessed value without triggering a reassessment of the
property for property tax purposes. As a result, two parents could transfer
their primary residence and another $2 million of the assessed value of real
properties without triggering a property tax reassessment.
As of February 16, 2021, per the provisions of the new
Proposition 19, children (or in some circumstances grandchildren) inheriting a
real estate property from a parent that is the parent's primary residence will still be entitled to the same portion
of the inherited real property but it will be subjected to a new taxation
system. .i.e. the elimination of parent-child and in some cases
grandparent-grandchild exclusion from property tax reassessment unless the
following two conditions are both fulfilled:
a.) The child (or under some
circumstances the grandchildren) MUST use the transferred property as their
primary residence within one year of the property's transfer;
b.) The primary residence exclusion
is limited to the first $1 million of the assessed value of the property at the
time of death or of the transfer by sale or gift.
The past exclusion from reassessment for a non-primary
residence of real properties is eliminated.
The Assessed Value for an inherited home would go up if the
price of the property could be sold for exceeds the property’s assessed value
by more than $1 million.
Below is an example designed to help you better understand
why the new property taxation rule could easily generate conflicts between
Mom dies owning her principal residence that she bought many
years ago which has a property tax of $4,000 per year and a current assessed
value of $1 million. Mom also owns another property with a current assessed
value of $1 million.
Child #1, receives mom’s principal
residence valued at $1 million and makes the property his/her principal
residence. As a result, child # 1 will be allowed to keep mom’s current
property tax value for this property. Child #2, receives the other property
also valued at $ 1 million.
This would appear to be an equal distribution with each
child receiving a property with a value of $1 million. But if we assume that
the property tax will increase 2% each year and that the property Child #2 is
receiving will be reassessed generating a new property tax based on 1.25%, then
over the next ten years child #1 will pay $776 in property taxes and Child #2
will pay $136,867 in property taxes.
3). Check with a professional all the tax implications of the sale of an inherited property before making
with Julie Wann, specialist of these
questions at Hoge - Fenton (access Julie Wann information here), people are sometimes reluctant to hire a tax expert when it comes to the
taxation of inherited real estate properties, mainly for 3 reasons:
They do not want to spend the money;
They have no idea that a tax expert can save them thousands of dollars by legally reducing the amount of the taxes to be paid;
They don’t know that a tax expert can assist to ensure a fair distribution of the decedent's assets between the beneficiaries.
Below are just a
few examples of how tax experts can help:
people assume that they will have to pay capital gains on the proceeds of the
sale of their inherited property. They lose sight of the fact that savvy use of
the tax basis and/or the step-up legislation can reduce and even sometimes eliminate
the amount of the capital gains tax.
Likewise, if the
inherited property is held in a trust before splitting the assets between the
beneficiaries it is essential to know how much tax each heir will pay on
his/her portion of the estate to avoid future disputes between them. (cf.
example in paragraph 2-2)
Lastly, if the
house is the most important asset of the deceased heritage, and one of the heirs
wants to keep the house but does not have enough money to buy out the other
beneficiaries, there are ways to generate cash out of the house to pay off the
heirs that are not interested in keeping the home.
To conclude, it
is stating the obvious that the sale of inherited properties is not as easy as it seems. Therefore, should you have any questions feel free to contact me.
Also, learn more
about when the probate court will be involved when a person died without a trust here.