Most people facing this question have just been handed a parent's house, a spouse's brokerage account or a share of a family home, often while still sorting out the funeral, the paperwork and the rest of the family's feelings. Someone has usually said that selling will mean a large tax bill, and an executor, a trustee or a co-heir is waiting for an answer before deciding what to do. This guide explains how the stepped-up basis works, how gain is measured, why the way title was held matters in a community property state, and how Proposition 19 property tax is a separate question.
What Stepped-Up Basis Means and Why It Matters
Basis is the starting value used to work out gain or loss when an asset is sold. If you sell for more than your basis, the difference is a gain. If you sell for less, it is a loss.
For inherited property, federal law resets that starting value. Under 26 U.S.C. § 1014(a), the basis of property acquired from a decedent is generally "the fair market value of the property at the date of the decedent's death." The basis is generally not what the parent or spouse originally paid. The statute allows a few alternatives, including an alternate valuation date that applies, according to the IRS page on selling inherited property, only if the executor files an estate tax return and elects it. This reset is called the step-up. When a home has grown in value over decades, the step-up can remove that lifetime growth from the gain calculation.
Receiving the inheritance is a separate matter from selling it. IRS Publication 559 states that property received as a "gift, bequest, or inheritance isn't included in your income." Income that the property later produces, such as rent, is taxable.
A gift made during life works differently. The IRS notes that "the rules are different" for property received as a lifetime gift. There is also a specific exception in 26 U.S.C. § 1014(e). If you or your spouse gave appreciated property to the decedent within one year before the death, and it comes back to you, your basis is generally the decedent's old basis and not the date-of-death value.
How Capital Gain Is Calculated When You Sell Inherited Property
The basic arithmetic is simple. Gain is the sale price minus your basis, and for inherited property that basis starts at the date-of-death value. The IRS states it plainly: "If you sell the property for more than your basis, you have a taxable gain."
Inherited property also gets favorable treatment for timing. Publication 559 says that when you sell inherited property that is a capital asset, "the gain or loss is considered long term, regardless of how long you held the property." Long-term treatment places the gain in a different category from short-term gain. How that category is taxed in a given year depends on the seller's whole return.
Basis does not always stay fixed after the death. IRS Publication 551 explains adjusted basis, which covers what can raise or lower basis after you acquire property. A preparer applies those rules to the actual records.
A loss is possible. An estate that sells a house in the middle of administration is a special case, though. Publication 559 explains that a loss is deductible when the estate holds the residence as an investment it intends to sell. A loss is not deductible when the estate holds the house for a beneficiary to live in.
California's income tax is administered by the Franchise Tax Board, which publishes current guidance on how the state return treats a sale.
Everything above rests on one number, the date-of-death value. That value usually comes from a qualified appraisal. A CPA, an enrolled agent or a tax attorney reviews the valuation and the gain calculation for income tax purposes.
Community Property, Joint Tenancy, and How Title Affects the Step-Up
How much of the property's basis is reset depends heavily on how the deed and accounts were titled. That question can feel technical while you are still finding the paperwork, but it is often the biggest factor in the tax result.
Community property. California is a community property state. Under 26 U.S.C. § 1014(b)(6), the surviving spouse's one-half share of community property is treated as acquired from the decedent. This applies only if at least one-half of the whole community interest was includible in the decedent's gross estate. Publication 551 puts it plainly: when either spouse dies, "the total value of the community property, even the part belonging to the surviving spouse, generally becomes the basis of the entire property."
Joint tenancy and other forms of ownership. 26 U.S.C. § 1014(b)(9) treats property that passes because of the form of ownership as acquired from the decedent to the extent it is included in the decedent's gross estate. As a result, how much of a joint tenancy share is stepped up depends on how much of it the estate includes.
Separate property. Separate property that passes by will, by inheritance or through the estate is covered by 26 U.S.C. § 1014(b)(1).
Revocable trusts. A revocable living trust does not take away the step-up. Under 26 U.S.C. § 1014(b)(2), property the decedent placed in a trust while keeping the right to revoke it is treated as acquired from the decedent.
How title was actually held is a factual question. Community property, joint tenancy, tenancy in common or a trust each lead to a different answer. A CPA or tax attorney checks the answer against the deed, the account records and the estate documents. For the broader picture of how a house passes, see this guide on inheriting a house in California.
Proposition 19 and California Property Tax Reassessment on Inherited Property
Families often treat Proposition 19 and capital gains as the same issue, but they are two different taxes. Reassessment changes the yearly property tax bill. Capital gains tax applies only when the property is sold. A higher reassessed value does not change the stepped-up basis, and the two are calculated independently.
For transfers on or after February 16, 2021, the parent-child exclusion is found in Rev. & Tax. Code section 63.2. It can also apply between grandparents and grandchildren, but only if all of the grandchild's parents who are the grandparents' children have died. The exclusion covers the transferor's principal residence when all of these conditions are met:
- the home becomes the transferee's principal residence within one year of the transfer;
- the transferee files for the homeowners' or disabled veterans' exemption within a year; and
- a claim is filed with the county assessor.
The exclusion is limited. If the home's market value is above the prior taxable value plus a dollar amount set in the statute, the excess is added to the taxable value. The county assessor's office can confirm the current figure. Property that does not qualify, such as a house that does not become the heir's home, is generally reassessed. Section 63.2 separately addresses family farms.
The claim deadline is generally within three years after the transfer, or before the property is transferred to a third party, or before an eligible transferee stops occupying the home, whichever comes first. A claim is also timely if it is filed within six months after the assessor mails a notice of supplemental or escape assessment. If the property has not gone to a third party, a later claim can still be considered, but it applies only from the lien date of the year it is filed.
A separate filing rule also applies. Under Rev. & Tax. Code section 480, a change in ownership statement is due within 150 days after the death. If the estate is probated, the personal representative files it before or at the time the inventory and appraisal is filed with the court.
The county assessor's office handles reassessment and exclusion claims. The choices that follow are compared in keep, rent or sell.
When an Inherited Property Sale Does — and Does Not — Trigger a Taxable Gain
Whether there is any gain depends mostly on timing and on how the property is used. The examples below are general patterns, not predictions for any particular estate.
A sale soon after the death. If the price is close to the date-of-death value, the gain is usually small or zero. The IRS estate tax FAQ notes there is "usually little or no gain to account for if the sale occurs soon after the date of death."
A sale years later. Any growth in value after the death is gain. It is still measured from the stepped-up value, not from the decedent's purchase price.
Several heirs. When heirs inherit together and one buys out the others, each seller's gain or loss is generally measured from that heir's share of the stepped-up basis. A disagreement among heirs over the property is a contested matter, handled by an attorney who litigates trust and probate cases.
Moving in. Under 26 U.S.C. § 121, gain from selling a principal residence can be excluded up to a dollar limit set in 26 U.S.C. § 121(b). To qualify, the seller must have owned the home and used it as a principal residence for periods totaling at least 2 years during the 5 years ending on the sale date. A surviving spouse's ownership and use generally include the deceased spouse's period, under 26 U.S.C. § 121(d)(2).
Renting first. Under 26 U.S.C. § 121(d)(6), the exclusion does not cover gain attributable to depreciation taken after May 6, 1997. Rental income is also taxable. Both are reasons to talk with a CPA or tax attorney before deciding to rent.
Reporting the Sale: Federal and California Returns
The paperwork is easier to face once you know which form holds what. Whoever sells reports the sale.
The IRS says a reportable sale goes on Schedule D (Form 1040) and/or Form 8949. The seller reports the stepped-up basis and the sale price, and treats the sale as long-term as described above. If the executor sent a Schedule A (Form 8971), the beneficiary may be required to use the estate tax value it shows. Under 26 U.S.C. § 1014(f), basis generally cannot exceed that value when the property increased the estate tax.
When the estate itself sells before distributing the property, Publication 559 explains that the estate reports the sale on its own income tax return, Form 1041, with Schedule D (Form 1041) and Form 8949. The California return follows the Franchise Tax Board's current guidance.
A CPA or enrolled agent typically prepares these returns. A tax attorney becomes involved when the treatment is disputed or complicated. The steps of the sale itself, such as listing, escrow and closing, are the selling process and are a separate subject. For the order of tasks around the sale, see the estate settlement checklist.
