• Bryan D. Eisenbise, Esq.

Avoiding Taxes Associated with Real Estate Upon Death

Although taxes associated with real estate are prevalent, understanding the exemptions and exclusions can save plenty on taxes especially when choosing a strategy to transfer ownership to a beneficiary as part of an overall estate planning strategy..

Before we jump into this, it is important to realize that entire classes are dedicated to the subject I am condensing into a single 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 feel free to reach out to us.

CAPITAL GAINS TAXES:  The best way to conceptualize the capital gains tax is to think of the gain as the "profit" (or "loss") realized as the result of a purchase and subsequent sale of a capital asset, which for purposes of our discussion will be one's real estate.  The purchase price of a piece of property is commonly referred to as the "cost basis,"  but the true definition of the term also includes the cost of any improvements made to the property (in addition to the purchase price) less any depreciation.  When a property is sold, the cost basis is deducted from the sale price, and the gain (or loss) is then calculated.  The gain is taxed at a high of 20% federally with an additional 3.8% surtax for high income earners. At the state level in California, capital gains are taxed at ordinary income tax rates. A capital loss is a deductible.  A high cost basis will always result in lower taxes (a smaller gain), than a lower cost basis.

With cost basis being such an important part of tax planning for real estate transfers, it is important to understand how various transfers affect cost basis, especially with estate planning. For example, gifting a property to a child has a dramatically different tax effect than bringing on the child as a co-owners, which also has a dramatically different tax effect than dying while owning the property and bequeathing it to the recipient.

  • When a property is sold in an arms length transaction, the cost basis is reset to the sale price for the purchaser. This is commonly referred to as a basis "step-up."

  • 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 stepped up 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 stepped up, whereas 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 stepped up 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 survivor.

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 actually avoided in most estate planning contexts.

REASSESSMENT OF PROPERTY TAXES:  The property tax is a tax assessed on the value of a piece of real estate.  This tax can increase or decrease the value of the property as it goes up and down, but many legislative protections are in place to prevent drastic movement.  It can be a little confusing because the core principles here with property taxes, appear to completely opposite of those with capital gains taxes.  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 they appear to be closely related, 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 the intermediate 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.