February 1, 2012

Property Taxes and Capital Gains

The notable Campbell, CA water tower down the street from my office

When somebody inherits real property and sells it thereafter, two important legal issues commonly arise, property taxes and capital gains. Property taxes in California are governed by Prop 13. Basically Prop 13 says that real property may be levied a 1% tax on the assessed value each year and the assessed value may be raised by no more than 2% annually. Capital gains is the tax imposed on a person when an asset is sold for a gain, namely the sale price exceeds the cost-basis. The following example illustrates how these legal topics relate to inheriting and then selling real property in California. 

The following individuals are fictitious characters invented through the limited powers of my imagination.

In 2008, Bobby Beneficiary, a resident of Mendocino, CA was informed by his Uncle George that his mother Ma Bell passed away and left her home in Campbell, CA to him through her will. Bobby's father Pa Bell had predeceased his mother. Ma and Pa Bell bought the home in 1980 for $10,000. Later in 2008, the will was probated and title to the Campbell home was transferred to Bobby from his late mother. Bobby was concerned that he will have to pay property taxes for the current value of the home, $600,000. However, Bobby was told by the probate attorney that this transfer qualifies for the parent-child exclusion and no re-assessment for property taxes will occur. Rev & T C § 63.1. Thus, Bobby was able to maintain the very low assessed value of the home, $10,000, for as long as he desires. This was particularly important for Bobby because he would rather not be forced to sell the property. Instead, Bobby would prefer to sell the property during a seller's market.

A few years later, in 2011, Bobby decides that the time is right to sell the Campbell home. Bobby was able to delay the selling of the home because property taxes were quite affordable given the low assessed value of the home. During the summer of 2011, Bobby finds a purchaser of the home and the parties agree to a purchase price of $650,000. Following the sale, Bobby becomes concerned over the enormous tax burden he will face next year when he files his taxes. The reason for Bobby's concern is that he has received shoddy accounting information over the years. Bobby has been deceived into believing, through viewing many late-night infomercials, that his basis in the property is $10,000. Hence, he erroneously believes that he will have a gain of roughly $640,000 (650,000-10,000). Yet in reality when Bobby inherited the property from his mother he received a new cost-basis in the property. When a person inherits property, the cost-basis is generally the date of death value of the asset.  IRC §1014(a); Rev & T C §18031. Here, the value of the Campbell home was $600,000 on Ma's date of death. Thus, Bobby's capital gains would in actuality be much smaller than he originally believed. That is, his capital gains would be $50,000 (650,000-600,000). Ultimately, Bobby's ability to inherit property from his mother, known as stepped-up basis, reaps enormous tax savings for him.

As you can see, inheriting property from somebody enjoys the best of both worlds, retention of old assessed value for property tax purposes and a stepped-up basis for the asset to reduce capital gains.