These are taxes paid on the appreciation of any assets that an heir inherits through an estate, and they are based on a step-up in basis.
What Is a Step-Up in Basis?
In a community property state such as California, there is a tax rule that allows the cost basis of an inherited asset to be adjusted to its fair market value at the time of the decedent’s death. This means that when someone inherits an asset, such as real estate, the original cost basis is “stepped up” to the asset’s current market value at the time of inheritance.
The step-up in basis reduces the capital gains tax liability for the beneficiary. If the asset has appreciated significantly, the beneficiary will only be taxed on the gains that occur after they inherit the asset, not on the appreciation that occurred during the decedent’s lifetime.
For instance, John and Mary purchased a house for $400,000 as community property, and at the time of John’s death, it is worth $1,000,000. Under the step-up in basis rule, the cost basis of the house is adjusted to its current market value of $1,000,000.
If Mary decides to sell the house later for $1,100,000, she would pay capital gains tax on the $100,000 gain ($1,100,000 sale price minus the $1,000,000 stepped-up basis), rather than on the $700,000 gain that would have applied without the step-up.
What Is a Double Step-Up in Basis?
As with a stepped-up basis, a double stepped-up basis can be highly advantageous for the surviving spouse and their heirs.
For example, if Mary decides to keep the house after John’s death, and at the time of her passing, the house is worth $2,000,000, their heirs will receive a “double step-up.” This means the heirs will inherit the house with a basis of $2,000,000, which reflects its value at the time of Mary’s death. As a result, they won’t owe capital gains tax on the full appreciation when they sell it for $2,000,000.
