Stepped-Up Basis: Why It Matters in California Estate Planning

Few features of federal tax law shape California estate planning as quietly as the stepped-up basis rule. A house bought in 1985 for $180,000 and worth $1.2 million today carries roughly a million dollars of unrealized capital gain. Whether the family ever pays tax on that gain — and if so, how much — depends largely on whether the property passes at death or is given away during lifetime.

This post is a short, plain-English overview of how the rule works, where it does and does not apply, and the planning choices it should inform.

The rule

When a person dies owning an asset, the asset's cost basis for federal income-tax purposes is generally adjusted (or "stepped up") to its fair market value as of the date of death (Internal Revenue Code § 1014). The beneficiary who inherits the asset takes that stepped-up basis, not the decedent's original cost.

In a community-property state like California, married couples get an extra benefit: when one spouse dies, the entire community-property asset typically receives a step-up in basis — both halves — provided the asset was held as community property at the date of death (IRC § 1014(b)(6)). This is one of California's quiet structural advantages over common-law states for married couples with appreciated assets.

What that means in practice

A worked example using round numbers, ignoring depreciation and exemptions:

• A married couple bought a San Diego home in 1990 for $250,000.
• It is worth $1,250,000 today.
• The husband dies first; the surviving wife inherits.
• The home was held as community property.
• The basis is stepped up — both halves — to $1,250,000.
• The surviving wife later sells the home for $1,300,000.
• The capital gain is $50,000 (sale price minus stepped-up basis), not $1,050,000.

Without the step-up, the same sale would generate a million dollars of capital gain. At blended federal capital-gains and California ordinary-income tax rates, the difference is substantial — often $200,000 or more.

What gets a step-up — and what does not

Generally gets a step-up:

• Real estate held individually, in joint tenancy with the spouse, or in a revocable living trust at death
• Stocks, bonds, mutual funds, and other taxable investment accounts
• Tangible personal property
• Closely held business interests (subject to valuation work)

Does NOT get a step-up:

• Tax-deferred retirement accounts (traditional IRAs, 401(k)s, 403(b)s). These pass under their own rules. The beneficiary inherits the account with its existing tax characteristics, and distributions are generally taxed as ordinary income.
• Annuities (most tax-deferred annuities). Similar to retirement accounts; gain is recognized as ordinary income to the beneficiary.
• Roth IRAs. Different reason — there is no embedded gain to step up because qualified distributions are tax-free anyway.
• Property given away during lifetime. Lifetime gifts generally carry over the donor's basis to the donee (IRC § 1015), which is the trap discussed in the next section.

The "putting kids on title" trap

A pattern the firm sees often: a parent — to "avoid probate" or "make things easier for the kids" — adds an adult child to title on the family home, or transfers the home to the child outright, during life. The intended outcome is to simplify estate administration. The unintended outcome is the loss of a step-up on the share of the property that has been gifted.

If the child inherits the same property at the parent's death (under a will or, better, a funded trust), the property gets the full step-up and the child can sell with little or no capital gain. If instead the parent gives the property to the child during life, the child takes the parent's basis — and the same later sale generates a substantial taxable gain that would not have existed had the property simply been retained until death.

The "we wanted to avoid probate" rationale is solvable in another way: a properly funded revocable living trust avoids probate and preserves the step-up. That is the right tool for the job in most cases.

Where stepped-up basis interacts with property tax

California's Proposition 13 protections and the parent-child reassessment rules under Proposition 19 are a separate body of law from the income-tax basis rules. The two operate independently. A transfer can preserve a Proposition 13 base without preserving income-tax basis, or vice versa, and a careful estate plan considers both.

For California families with long-held appreciated real estate, the firm's standard analysis at the consultation includes:

• The current income-tax basis in the property
• The likely sale path and timing
• Whether the property will be retained, sold, or rented after death
• The Proposition 19 implications for the chosen transfer route
• The interaction with any prior gifting

These considerations together drive whether the property should sit in the trust, be held in joint tenancy, or be gifted in stages — and the right answer is rarely the same for any two families.

Practical takeaway

For Californians with significantly appreciated real estate or investments, the income-tax cost of getting the transfer mechanics wrong often dwarfs the cost of doing the planning right. A revocable living trust that preserves the step-up at death and avoids probate is, in most cases, simply better than gifting during life — and it is one of the most common reasons clients walk out of an estate-planning consultation having scrapped a "let's just put the kids on title" idea.

If you have appreciated California real estate or investments and want to talk through the planning options, please reach out.

This article is general information and not legal or tax advice. Federal income-tax basis rules and California property-tax rules are subject to change; specific situations need specific review with current authority.