Before we jump into this, it is important to realize that entire classes are dedicated to the subject I am condensing into a simple blog post. There are plenty more tax considerations than what is addressed here, and there are a near-infinitely higher number of strategies to avoid these taxes as well. The scope of what we are covering here will encompass the most asked-about taxes in the most common scenarios. If you would like specific advice for your current situation, please contact us.
- When a property is sold in an arms length transaction, the Cost Basis is reset to the sale price for the purchaser.
- When a property is gifted, the Cost Basis is "carried over" to the recipient, and the recipient must declare the original Cost Basis of the giver as his/her own Cost Basis.
- When a property is sold at less than fair market value, the Cost Basis is reset to the extent of the portion of the property that was sold, and carried over to the extent of the portion of the property that was effectually "gifted."
- When a joint owner on a piece of property dies, and that portion of the property transfers to the surviving joint owner by virtue of the title (joint tenancy), the Cost Basis of the portion of the property of the decedent is reset, where as the portion of the Cost Basis of the portion of the property of the survivor continues as it was before.
- When a joint owner spouse dies, and the property is held as "Community Property," the Cost Basis of the entire portion of the property is reset for the surviving spouse.
- When a house is passed through a Will or a Trust to a surviving beneficiary (even if that beneficiary is also a joint owner of a piece of property), the Cost Basis of the entire portion of the property is reset for the surviving spouse.
In sum, a "carried over" Cost Basis is to be avoided, as it would result in higher Capital Gains Taxes. In looking over the above explanations, the best way from a Capital Gains perspective is to transfer the property by virtue of a Will or Trust, or by holding it as Community Property with a spouse, but factoring in other benefits, holding property in a Trust will almost always be the most preferable.
DOCUMENTARY TRANSFER TAXES: The Documentary Transfer Tax is a relatively small tax (a few hundred or couple thousand dollars), and is assessed upon the sale of a property, and is essentially a tax on the "transfer" of a property (think sales tax for real estate). This tax is assessed and paid one time per transfer, and is based upon the value or sale price of the property. The California Revenue and Taxation Code Sections 11921 -11930 go over the exceptions to this tax. Pay close attention to Section 11930, as it exempts this tax on any transfer by way of gift, transfer in or out of a Trust, or by way of death. As so, this ever-present tax on real estate transfers is avoided upon death.
REASSESSMENT OF PROPERTY TAXES: The Property Tax is a tax assessed on the value of a piece of real estate. This tax can increases or decrease of the value of the property goes up and down, but many, many protections are in place to prevent drastic movement, if any with ones tax liability in this area. It is also a little confusing because the foundational principles here, appear to contradict those of the Capital Gains tax. With the Capital Gains Tax we focused on the Cost Basis, which we want to be very high, which results in a smaller gain, whereas with Property Taxes, we want the assessed value of the property to remain low, because the tax is based on that value. Although at first glance the appear to be the same, they are totally different, and from a tax perspective, it is more preferable to have a higher Cost Basis, and a lower assessed value. The value of a piece of real estate is reassessed, among other occurrences, each time the property is transferred. Like the Documentary Transfer Tax, there are plenty exemptions here as well. These exemptions, however, are not exemptions of the tax, but exemptions of reassessment. There are certain strategies involving business entities and proportional interests which could result in a lack of reassessment, but for the purposes of our discussion, it is the transferor's relationship to the recipient which will ultimately determine the existence of an exemption. Under certain provisions of the famous "Proposition 13" there is no reassessment when one spouse dies leaving it to another. Nor is there a reassessment if one joint owner dies leaving the ownership solely with the survivor (certain conditions must be met). But most popular is Proposition 58, which exempts a property from reassessment if the transfer is from parent to child (or grandchild if a parent is deceased).
One obvious fact about taxes associated with real estate is that the existence of a Living Trust is not a silver bullet, and that many taxes can be avoided in many other ways as well. Nevertheless, when looking at the totality of the circumstances, a Living Trust, if properly drafted, will result in avoiding many, if not all taxes associated with real estate, while at the same time, preserving the many, many other benefits of having a Trust.