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Real estate is taxed in two ways: 1) Annual property taxes, 2) Capital gains tax when the property is sold. Upon a homeowner’s death, there may be significant ramifications to both types of taxes.....
Minimizing Property Taxes
In California, property taxes are based on the assessed value (generally established by adding the purchase price + possible 2% increase per year). Property is then reassessed at market value when sold or transferred, often resulting in dramatic property tax increases.
For example, a home purchased in 1960 for $100,000 could have an assessed value of $274,000 ($100,000 price + 2% increase per year since 1960). However, the actual value of the home might be $900,000; which means a buyer of the home at that price would pay taxes on a $900,000 assessed value. This same tax increase could apply to the heirs of the property upon the owner’s death.
However, if certain guidelines and filing requirements are met, Proposition 58 excludes real property transfers from being reassessed. This is HUGE as it allows heirs to maintain the much lower property taxes!
Minimizing Capital Gains Taxes
When a property is sold, capital gains taxes may be due on the profit (price minus cost basis). Cost basis is essentially the home’s purchase price +/- certain expenses, depreciation, etc.
For example, a home purchased for $100,000 (with $20,000 in expenses) would have a $120,000 cost basis. If the home is sold for $900,000, capital gains tax might be due on $780,000 in profit ($900,000 minus $120,000); which could result in a six-figure tax liability. Those same capital gains taxes could apply to the heirs of a property when the home is sold.
However, if the home is transferred to heirs after the owner’s death via living trust, instead of heirs being added to title prior to the owner’s death, the heirs can receive a "step-up" in cost basis for capital gains purposes (namely the value of the property on the date of the owner's death).
So in the same example above, if the owner had title in a trust and passed away when the property was worth $850,000, the capital gains would only be the difference between the $900,000 sale price and the $850,000 "stepped up" basis. So capital gains would be on $50,000 in profit vs. $780,000 in profit. This can significantly limit the capital gains tax!
And selling expenses (realtor fees, etc.) would likely wipe out that $50,000 in gains anyway, leaving the possibility of no taxes being due. So be careful how you handle title on a home.
If handled properly, it is possible to achieve the best of both worlds when it comes to minimizing taxes upon a homeowner’s death.