I receive a lot of questions about capital gains and property taxes – rightfully so, as they are complicated. Let me start off with a disclaimer: I am neither an accountant nor an attorney.
I cannot give tax or legal advice, but I am the one who gets all the questions, so let me answer some of the basics. Please consult your accountant or attorney on the specifics of your situation.
Q: I have heard about a “stepped-up basis” on my property. What does this mean?
A: There are other cases where this will apply, but the main one I see is that upon the death of the first of the owners (husband or wife) of a house, the cost basis – the value the IRS uses to determine what you paid for the house – “steps up” to the market value of the house at his or her date of death.
For example, for homeowners who bought their house in 1975 for $100,000, this becomes their cost basis. Their house is now worth $2 million. If either the husband or wife dies, the new cost basis for their house would be $2 million.
Q: Why is the cost basis so important?
A: When you sell your house, capital gains taxes are essentially calculated as a percentage of the difference between the cost basis and the sales price.
You may also deduct improvements you have made to the house, and you may deduct $250,000 per person or $500,000 per couple.
From the example above, if the surviving spouse sells the house after the death of one of the owners for $2 million, the capital gains would be zero – deducting a cost basis of $2 million from a sales price of $2 million.
Q: Why is this important?
A: There are multiple impacts.
• There may be a tendency for married couples to wait until one of them dies to essentially avoid the capital gains tax. This has the effect of reducing housing inventory, which tends to make prices rise.
• The savings can be substantial. For example, if a couple’s capital gains were 35% and they sold their house for $2 million while they were both still alive, the tax would be approximately $490,000 ($2 million sales price, minus the $100,000 cost basis, minus the $500,000 exemption, multiplied by 35%).
Q: What about property tax. How is it calculated?
A: Property tax is based on the price you paid for your home and is charged at 1%. This number is allowed by Proposition 13 only to increase by up to 2% per year.
Any parcel taxes are added to that number. Parcel taxes are charged equally on every parcel regardless of value and are typically voter-approved for services such as schools, sewers and vector control.
As a rough number, figure that you will pay 1.25% of your purchase price in property tax annually, increasing approximately 2% per year.
Q: What happens if I sell my house to my kids?
A: There are provisions in the code that will allow your low Proposition 13 tax basis to transfer to certain related family members. So if you sell your house to your kids, they get to keep your low tax rate.