Capital Gains Tax and Property Tax Transfer on Inherited Assets
Inheritance and Capital Gain
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 Beneficiaries generally do not have to pay income tax on property they inherit – with the common exception of money withdrawn from an inherited retirement account (IRA or 401(k) plan).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.
Below is a recap, for informational purposes only, of the most common situations involving capital gain and inherited real estate property.
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 $20,000.
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. 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 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 property is held for a long time, its value generally does go up. But 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 simply the date-of-death market value.
Be aware that for very large estates if the estate owes estate tax (that means there must be more than $11.4 million in net assets), 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 the death.
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 result is 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 that 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 transaction.
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 property 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 part of a parent’s home or sometimes a parent might gift part of their resident to a child in order to avoid probate.
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 in the half he or she inherits. They already owned the other half-interest, so their basis stays the same. That means that the new basis is $175,000. The basis in the original half-interest is still $75,000, and the basis of the inherited half-interest is $100,000.
Community property
In community property states such as California married couples get a tax advantage. Both halves of 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%. So in the example above, the surviving spouse would have a new fresh start tax basis of $200,000 after the first spouse dies.
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 gift and prevents taxpayers from shifting an asset with an unrealized loss to someone else to offset an otherwise taxable capital gain.
This summary is provided to you for informational purposes only. Please seek the advice of your tax advisor and/or estate lawyer for your specific circumstances. Sources: www.alllaw.com, Barnett Accounting
Property Tax Reassessment on Inherited Assets
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 or (and under some circumstances to their grandchildren, 2.) it provides property tax relief to a select group of people.
Proposition 19 and Property Tax Transfers
Under the former property tax law, parents can 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 assessed value of real property without triggering a property tax reassessment.
As of February 16, 2021, per the provisions of the new Proposition 19, children (or in some circumstance grandchildren) inheriting a real estate property from a parent 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:
1.) The child or under some circumstances to the grandchildren MUST use the transferred property as their primary residence within one year of the property's transfer;
2.) The primary residence exclusion is limited to the first $1 million of 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 deadline to transfer real properties without triggering the new reassessment rules under Proposition 19 is February 15, 2021.
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.
Example 1:
On March 1, 2021, Parents' principal residence has a factored base year value of $250,000. The excluded amount is $1,250,000 ($1,000,000 plus $250,000 Property Tax Rule 462.520 factored base year value). Parents transfer 100 interest in their principal residence to Child on March 1, 2021.
Alternative 1: Zero excess amount. The principal residence has a full cash value of $900,000 on the date of transfer. Since $900,000 is less than the $1,250,000 excluded amount, the excess amount is zero. Therefore, the new taxable value on the date of transfer is the factored base year value of $250,000.
Alternative 2: There is an excess amount. The principal residence has a full cash value of $1,300,000 on the date of transfer. Since $1,300,000 is greater than the $1,250,000 excluded amount, there is an excess amount of $50,000. Therefore, the new taxable value of the principal residence on the date of transfer is $300,000 ($250,000 factored base year value plus $50,000 excess amount).
Example 2
This example is designed to help you better understand why the new property taxation rule and could easily generate conflicts between family members:
Example 1:
Mom dies owning her principal residence that she bought many years ago that 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 $1million.
This would appear to be an equal distribution with each child or grandchild 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 property tax based on 1.25%, then over the next ten years child or grandchild #1 will pay $776 in property taxes and Child #2 will pay $136,867 in property taxes.