Step-up in cost basis: What California residents need to know

When you inherit assets, it can be confusing to understand how much, if any, tax you will potentially have to pay on them. In this blog, we are going to discuss what California residents need to know about step-up in cost basis.

You will learn:

·       What is a capital gain, how do you pay capital gains tax in California, and what are capital gains tax rates in the state of California?

·       What is step-up in cost basis?

·       What is double step-up in cost basis?

·       How step-up in cost basis works in the State of California at the death of a spouse

·       How step-up in cost basis works with community property

·       Is there a step-up in cost basis before you die?

·       Does life insurance incur a step-up in cost basis?

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What you need to know about step-up in cost basis in California

Before we get into the details, let’s start by defining some key terms.

What is a capital gain?

A capital gain is the difference between the price you receive when you sell an asset, and the price you paid when you bought the asset. Let’s use a simple example.

·       If you bought a stock for $100,000 and sold it for $300,000, your capital gain is $200,000.

·       If you were to sell the stock for lower than what you paid for it, let’s say $50,000, you would have a capital loss.

In the state of California, as in many states, you are potentially liable to pay capital gains taxes upon the sale of an asset. How do California residents file capital gains? In California, all capital gains are taxed as ordinary income. You report your capital gains to the Federal government using IRS Form 1040, 1040 SR. California residents also must file California Schedule D (540).

Any views expressed in this article, by the way, cannot be construed as advice specific to any one individual. If you have any questions about how to file your taxes, or questions about any matters related to taxation of assets in the state of California or elsewhere, it is recommended that you speak with a tax advisor.

Capital gains tax is incurred upon the sale of assets such as stocks, bonds, real estate, artwork, and many others. To gain insight as to what tax rates apply to California residents, please view the 2020 California Tax Rate Tables.

What is step-up in cost basis?

Step-up in basis is also referred to as “the step-up in cost basis loophole.” It is especially important for California residents, as well as residents of other states, who expect to inherit assets, in particular assets that may carry a large capital gain such as real property. Most of the time when property is inherited, it is sold for much more than its original purchase price.

Let’s say you were to inherit an asset whose value has increased since it was acquired by the original owner. The original cost basis of the asset is essentially wiped clean and replaced by its current market value. This way, the capital gain is minimized for the beneficiary. This is called a step-up in cost basis, and it is rendered upon transfer of the asset which usually occurs upon the death of the decedent.

We want to emphasize the step-up in basis occurs upon the death of the decedent. For example, for married couples in the state of California; the step-up in cost basis occurs at your spouse’s death.

What is double step-up in basis?

Before moving on to our discussion of double step-up basis, we wanted to invite you to sign up for our newsletter. We frequency publish articles on financial topics particularly relevant to successful individuals and families in the state of California such as Prop 19 and other California regulatory developments.

Step-up in basis has a special application for residents of community property states such as California. There is what we call the double step-up in basis that may apply to your situation. When one spouse dies, the surviving spouse receives a step-up in cost basis on the asset. Then when the surviving spouse passes, the asset is stepped up again.

In other words, an inherited asset gets stepped up twice in a community property state: once for the surviving spouse and a second time for the ultimate beneficiary. This has tremendous potential to reduce the amount of capital gains tax paid by the ultimate beneficiary.

Common step-up basis mistakes

There are a few pitfalls we often see when it comes to the step-up in cost basis.

·       Remember that assets also are stepped down at the time of death. Think about this when deciding to assign the assets to a beneficiary.

·       Joint tenancy has special implications that California residents should be aware of. If you hold a home in joint tenancy with your spouse, the surviving spouse retains the original cost basis on 50% of the home instead of getting a step-up in basis on the entire home. **

·       If you own a home with your child as joint tenants, your child will only receive a step up in basis on your half of the value of the home when you die.

·       Life insurance does not receive a step up in cost basis because life insurance proceeds are normally received income tax free by the beneficiaries.  

There are certain things you can do to avoid these mistakes with step-up in cost basis. As stated before, it is suggested that you speak with a tax or financial advisor to handle these issues properly.

** Note on Joint tenancy: If you have evidence to show that the jointly held property is in fact community property, you may be able to petition the court for it to be changed. In addition, some tax preparers may claim that the joint property between spouses should be presumed to be community property based on the circumstances. While these may be possible options, we don’t think they can provide reliable results.

When step-up in basis does not apply

Step-up in basis is not a simple subject. Here are some of the questions we tend to get regarding assets getting stepped up in basis. Some assets do not get a step-up in basis, such as assets held in an IRA, 401(k), Bypass or Credit Trust. Also, step-up in cost basis only occurs upon death. There is no way to recognize a step-up in basis while the original owner is still alive.

There are many more situations that preclude an individual from recognizing a step-up in basis. For advice specific to you, consult a tax professional.

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