The largest transfer of wealth in American history is already underway. According to Cerulli Associates, a leading global research and wealth management consulting firm, approximately $124 trillion is expected to change hands through 2048, with nearly $105 trillion transferring to heirs. A substantial portion of this wealth consists of highly appreciated real estate, including apartment buildings that have been owned for decades.
This historic transfer of wealth presents opportunity and risk. As families prepare to pass highly-appreciated real estate to the next generation, a good understanding of the tax consequences has become increasingly important. Experienced investors understand that allowing appreciated property to pass through inheritance, rather than transferring it during their lifetime, can produce significant tax savings through a step-up in basis.
This article explains how the step-up in basis works, California’s double step-up concept, and a checklist to help ensure an estate plan involving real estate is coordinated.
Understanding Three Basic Terms
It first helps to understand three basic tax concepts:
- Cost Basis: Cost basis begins as the amount paid to acquire a property, plus certain acquisition costs. Cost basis may increase over time as capital improvements are made, such as major renovations or additions. It may decrease due to deductions taken on investment property. Over time, the resulting figure is known as the property’s “adjusted” basis.
- Capital Gain: Capital gain is generally calculated by subtracting the property’s adjusted basis and eligible selling costs from its sale price. Realized capital gain is subject to federal and state capital gains taxes.
- Step-Up in Basis: Real estate inherited from a decedent receives a new tax basis equal to its fair market value on the date of the owner’s death. In simple terms, the IRS allows the property’s tax basis to be “reset” to its current market value. Instead of inheriting the decedent’s original adjusted basis, heirs can inherit the property’s fair market value as of the date of death. For highly appreciated real estate, this can dramatically reduce, or even eliminate, capital gains taxes when the property is later sold.
Unique Tax Advantage for Married Couples: Double Step-Up
California provides an additional estate planning advantage because it is a community property state. Real estate acquired during marriage in California is generally considered community property. When the first spouse dies, both the deceased spouse’s one-half interest and the surviving spouse’s one-half interest in community property real estate can receive a step-up in basis to the property’s fair market value as of the date of death.
This creates a significant tax benefit. If the surviving spouse sells the property shortly after the first spouse’s death, capital gains taxes may be substantially reduced or even eliminated. Alternatively, if the surviving spouse retains the property until his or her own death, the property receives another basis adjustment to its then-current fair market value before passing to the heirs, potentially eliminating capital gains tax on appreciation that occurred during the surviving spouse’s lifetime.
Check-List of Steps
For owners who have accumulated significant appreciation over many years, preserving family wealth requires planning. Consider these practical steps:
- Identify your highly-appreciated assets: Determine which assets have accumulated substantial unrealized gains. Consult with a qualified tax advisor on which specific assets benefit from a stepped-up basis.
- Coordinate gifting decisions carefully: Before transferring appreciated property during your lifetime, understand the tax trade-offs. Lifetime transfers can strip your heirs of a future step-up in basis, eroding legacy wealth.
- Review your estate plan periodically: Ensure your trusts, ownership structures, and beneficiary designations align with the overall estate plan. Review at regular intervals.
- Discuss the process with your family: Heirs are frequently unaware that a stepped-up basis exists. Helping them understand these tax rules ahead of time empowers them to make informed decisions.
- Assemble the right advisory team: Your real estate broker, tax advisor, financial planner, and estate planning attorney must understand your long-term objectives. Ensure they work together to help preserve family wealth.
Final Thoughts
Successful real estate strategies focus on preserving wealth, minimizing unnecessary taxes, and setting the next generation up for success. Understanding the step-up in basis is an important part of that process and can help ensure that more of what you built stays with your family rather than being lost to avoidable tax consequences.
Disclaimer: The tax and legal concepts discussed in this article are provided for educational purposes only. The outcome in any particular situation depends on numerous factors, including a property’s ownership structure, the terms of any trust or will, an individual’s tax circumstances, and whether the property is characterized as community property or separate property. Readers should consult qualified tax and legal advisors regarding their specific circumstances before making any estate planning or tax-related decisions.
Eric Lowe is a real estate broker and founder of Pierson Post, a commercial real estate brokerage based in Bonita, CA. He began his career as an attorney handling complex real estate transactions across Southern California. As a broker, Eric helps owners decide when and how to sell, designs targeted marketing strategies, and guides 1031 exchanges. He blends institutional deal expertise with boutique client service. Call Eric at 619-813-7583 or email him at elowe@piersonpost.com.