Did your spouse leave you real estate? 💡

A client recently asked a crucial question: “If Spouse A deeds their portion of a home to Spouse B who is terminally ill, and then inherits it back after Spouse B passes away, does Spouse A get a full step-up in basis?”

This scenario brings up a critical, but often misunderstood, tax rule: IRC Section 1014(e). This “deed-to-die” rule states that if a person gives appreciated property to a dying relative and then inherits it back within one year of the death, they do not receive a step-up in basis. This prevents the intentional use of a death to avoid capital gains taxes.

The solution to a full step-up in basis depends on how the property is owned:

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Community Property States

The following are community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In these states, the entire property generally receives a full step-up in basis upon the death of the first spouse. According to IRC Section 1014(b)(6), if at least half of the community property is included in the deceased spouse’s gross estate, the entire property’s basis is stepped up to its fair market value on the date of death. This is a significant advantage, as it erases capital gains tax on the appreciation of the entire property. The strategy of deeding the property is unnecessary and could complicate the situation. For more information, refer to IRS Publication 555, Community Property.

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Common Law States (Joint Tenancy)

In the majority of U.S. states, which are common law states, property is often owned as joint tenants with rights of survivorship (JTWROS). In this case, only the deceased spouse’s half of the property receives a step-up in basis. The surviving spouse’s half retains its original cost basis. The plan to deed the property in a common law state falls directly under the “deed-to-die” rule, meaning a full step-up would not be achieved. The most effective solution here for getting a full step-up would be to transfer the property to a living trust.

A revocable living trust is a key strategy for this scenario. By transferring the home to a trust, the entire property is included in the deceased spouse’s gross estate under IRC Section 2038, which allows the entire asset to receive a full step-up in basis under IRC Section 1014, effectively resetting the cost basis for the surviving spouse and eliminating capital gains on the entire home. This is not a tax loophole, but a legitimate legal and tax strategy.

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California Property Tax Reassessment Exclusion

For clients in California, an important additional layer to consider is property tax. The state has an interspousal transfer exclusion which states that a transfer of property between spouses does not trigger a property tax reassessment. Additionally, under Proposition 19, a transfer of a primary residence from a parent to a child is now subject to a property tax reassessment, unless the child uses the property as their own principal residence. However, the original property tax base can be retained with an adjustment. It is critical to consult a professional to ensure this transfer is handled correctly and a reassessment is not triggered unnecessarily.

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Texas Property Tax Notes

In Texas, while property is reassessed annually to market value, the homestead exemption provides a significant benefit for primary residences. For properties with a homestead exemption, the appraised value for tax purposes can only increase by a maximum of 10% per year, regardless of the increase in market value. This is known as the homestead cap. When a spouse inherits a home, they can continue to claim the homestead exemption, and the transfer generally does not reset the 10% cap. This provides a valuable, ongoing property tax benefit to the surviving spouse.

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Washington Property Tax Notes

In Washington, a transfer of property between spouses or registered domestic partners does not trigger a change in ownership for property tax purposes. This means that deeding a property to a spouse will not cause a property tax reassessment. A transfer of property upon death to a surviving spouse is also exempt from reassessment. The tax basis of the property will be stepped up, but the property’s assessed value for property tax purposes remains the same. This allows the surviving spouse to avoid a potentially significant increase in their annual property tax bill.

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Property Tax Reassessment Notes for Other Community Property States

In Arizona, Idaho, Louisiana, Nevada, New Mexico, and Wisconsin, the laws for property tax reassessment are similar to those in Texas and Washington. Generally, a transfer of property between spouses, including through inheritance upon the death of one spouse, is exempt from being considered a “change in ownership.” This is a key benefit that allows the surviving spouse to inherit the property without a new, and potentially much higher, tax assessment. This complements the federal full step-up in basis and helps preserve the long-term affordability of the home

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It’s a reminder that sophisticated tax and estate planning requires a deep understanding of complex regulations. Always consult a professional for legal and tax advice to ensure your clients’ strategies are sound.

Please reach out if you have questions.

#CPA #TaxProfessional #TaxPlanning #EstatePlanning #IRCSection1014e #TaxLaw