Capital Gains Resets With Inheritance

When a beneficiary inherits assets, the cost basis is adjusted to the fair market value at the decedent’s date of death under IRC §1014. This adjustment is commonly known as a step-up in basis. If you buy a stock for $100,000 and it grows to $1 million, selling it during your life triggers capital gains tax on the $900,000 appreciation. If you hold it until death, your heir receives the stock with a new cost basis of $1 million. They can liquidate it immediately and owe zero income tax. If they sell it later for $1.1 million, they only pay tax on the post-death gain of $100,000.

Trusts and the step-up: the rule people invert. You will be told, confidently and by people selling something adjacent, that assets must stay out of a trust to receive the step-up. That is wrong, and acting on it buys you probate for nothing. IRC §1014 does not ask whether an asset sat in a trust. It asks whether the asset was included in your gross estate.

A revocable living trust is a grantor trust whose assets are pulled back into your estate under IRC §2038 precisely because you kept the power to revoke it. Everything inside receives a full step-up, exactly as if you had held it in your own name — which is why the revocable trust is the standard probate-avoidance vehicle and why it costs you nothing in basis. The same is true of a home, a rental portfolio, or a chain of 1031 replacement properties held that way.

What forfeits the step-up is an irrevocable transfer that succeeds in removing the asset from your estate: a funded bypass trust (section “Bypass Trusts”), a completed gift to a dynasty trust, a QPRT that runs its term. Those take carryover basis under IRC §1015, and that is the actual trade — estate tax avoided now against capital gains tax paid later by your heirs (section “Optimizing for Basis in the High-Exemption Era”). In the high-exemption era that trade is frequently a bad one, which is why deliberate estate inclusion — a retained limited power of appointment, or the IRC §675(4)(C) substitution power used to swap high-basis assets into the trust and pull the low-basis ones back before death — is now a mainstream technique, not a mistake. The question is never trust or no trust. It is in the estate or out of it, and you should know which one each asset is in.

Joint Tenancy with Right of Survivorship vs. Tenancy in Common

The legal form of asset co-ownership dictates how this step-up is applied. Married and unmarried co-owners typically choose between Joint Tenancy with Right of Survivorship (JTWROS) and Tenancy in Common (TIC).

Joint Tenancy with Right of Survivorship

JTWROS requires two or more co-owners to hold equal, undivided shares in an asset. When one owner dies, their share automatically passes to the surviving owner by operation of law. This transfer bypasses probate entirely, simplifying estate administration. However, adding a non-spouse as a joint tenant during your lifetime is treated as a taxable gift of a fractional interest, which requires filing Form 709 if the value exceeds the annual gift tax exclusion ($19,000 in 2026).

Tenancy in Common

TIC allows two or more parties to own unequal or equal fractional interests in a property. There is no right of survivorship. Each owner’s share is distinct and can be bequeathed via a will or trust to any beneficiary they choose. When a tenant in common dies, their share goes through probate (unless held in a trust) and is included in their taxable estate.

The basis adjustment rules differ significantly between the two. Under a TIC structure, only the decedent’s fractional interest passes to their heirs, and only that portion receives a basis step-up to its date-of-death value. The surviving co-owner’s basis in their own share remains unchanged.

Joint Tenancy Basis Adjustment: Non-Spouse vs. Spouse

For non-spouse joint tenants (such as a parent and child), the cost basis adjustment depends on the contribution rule. When a non-spouse joint tenant dies, the IRS presumes the decedent paid for 100% of the asset, including the entire value in their gross estate under IRC §2040(a), unless the survivor can prove they contributed capital. The adjusted cost basis for the survivor is the sum of:

1.

The date-of-death fair market value of the portion included in the decedent’s estate.

2.

The survivor’s original cost basis in their own interest.

For spouses holding property as joint tenants, the rules are different. Under IRC §2040(b), only 50% of the property is included in the first-to-die spouse’s gross estate, regardless of who paid for the asset. Consequently, only 50% of the property receives a basis step-up. The surviving spouse’s new cost basis is calculated as:

1.

One-half of the fair market value of the property at the date of death.

2.

Plus one-half of the original cost basis.

3.

Minus the surviving spouse’s share of any depreciation taken on the property before death.

This partial step-up is a significant disadvantage when compared to community property titling.

Community Property vs. Joint Property

If you are domiciled in a community property state (such as California, Texas, Washington, or Arizona), holding title to appreciated assets as joint tenants is a costly mistake. Under IRC §1014(b)(6), community property receives a double step-up: when the first spouse dies, 100% of the community property receives a new basis adjusted to the fair market value at death.

Write the two rules side by side and the entire argument fits on one line. For an asset with basis $B$ and date-of-death value $V$:

Joint tenancy hands the survivor exactly half of the embedded gain, every time, no matter how the asset was paid for. Compare two scenarios for a California couple holding a brokerage portfolio that has grown from an original cost basis of $1 million to a fair market value of $5 million, assuming the survivor liquidates it and other income fills the lower brackets (Table 23.14). Under JTWROS only the decedent’s 50% share steps up, leaving the survivor a $\frac{1}{2}(\$1\text{M})+\frac{1}{2}(\$5\text{M})=\$3$ million basis and a $2 million taxable gain on sale. Held as community property, the entire basis steps up to $5 million and the survivor sells at zero gain.

The California figure reflects the top 13.3% rate, which includes the 1% Behavioral Health Services Tax surcharge on taxable income above $1 million; the 3.8% line is the net investment income tax (section “Net Investment Income Tax (NIIT)”). Choosing joint tenancy instead of community property costs the surviving spouse roughly $742,000 in unnecessary taxes. In community property states, JTWROS is a massive financial leak.

To obtain the double step-up, spouses can hold title as “community property” or “community property with right of survivorship” (which combines the full basis step-up with probate avoidance). Spouses can also convert separate property into community property by executing a transmutation agreement under state law, as detailed in section “Separate Property, Community Property, and Commingling”. For more details, consult IRS Pub. 555, IRS Pub. 551, “Basis of Assets”, and IRC §1014.

Common Law States: The Tennessee Community Property Trust

If you live in a common-law state (any state other than the nine community property jurisdictions), you are normally locked out of the double basis step-up. However, Tennessee, Alaska, Florida, Kentucky, and South Dakota allow non-residents to opt into community property treatment by establishing a Community Property Trust. Under the Tennessee Community Property Trust Act (T.C.A. §35-17-101 et seq.), spouses can transfer assets to a trust that explicitly elects community property status.

To qualify, the trust must have at least one qualified trustee (a Tennessee resident or a corporate trustee located in Tennessee) and carry explicit statutory warnings. If structured correctly, the assets held in the trust should qualify for a 100% basis step-up upon the death of the first spouse under IRC §1014(b)(6). While the IRS has not issued a formal revenue ruling validating this for non-residents of opt-in states, the statutory language of IRC §1014(b)(6) refers to property that is considered “community property under the laws of any State.” If you hold highly appreciated real estate or business interests and live in a common-law state, price the second step-up before you dismiss the idea: on a $5 million position with a $1 million basis, the difference between one step-up and two is roughly $742,000 of tax (Table 23.14). That is worth an afternoon with counsel and a Tennessee trustee’s fee schedule.

The Other Step: California Proposition 19 and the Property-Tax Reassessment Trap

The income-tax step-up under IRC §1014 and California real property tax reassessment rules are governed by different statutes, and confusing them can lead to substantial annual property tax increases. Under California Proposition 13, the assessed value of real property is locked at acquisition and grows at a rate capped at 2% per year. However, transferring a property by gift, will, trust, or entity transfer typically triggers a change in ownership that resets the assessed value to current fair market value under Proposition 19 (effective February 16, 2021). The parent-child exclusion that historically protected these transfers is now limited: a child must occupy the property as their principal residence within one year of the transfer, and the excluded assessed value is capped at the parent’s prior assessed value plus $1 million (indexed). If the property is used as a rental, secondary home, or commercial space, reassessment is immediate and complete.

The math illustrates the impact. Proposition 13 caps assessed value growth at 2% a year, so a property held for $n$ years carries an assessed base of $A_n=A_0{(1.02)}^n$ against a market value that has compounded at the real rate. Parents who purchased a Bay Area residential rental in 1985 for $500,000 hold an assessed base of

against a fair market value of $5 million, for an annual bill of roughly $\$1.1\text{M}\times 1.1\%\approx \$12,000$. If the property passes to a child who keeps it as a rental, Proposition 19 resets the assessed value to market and the bill becomes $\$5\text{M}\times 1.1\%=\$55,000$—a permanent $43,000 a year, which capitalized at a 5% discount rate is an $860,000 hit to the property’s value. That dwarfs the income-tax benefit of the basis step-up unless the heirs sell almost immediately, which is precisely the decision the numbers are telling them to make.

To manage this reassessment exposure:

Multi-generational LLC structuring

Hold the real property inside an LLC. Under California Revenue and Taxation Code §§64(c) and 64(d), property is only reassessed if a single buyer acquires more than 50% of the LLC’s voting control, or if original co-owners cumulatively transfer more than 50% of their initial interests. By structuring transfers of minority LLC interests over time, you can defer reassessment. The LLC must operate as a legitimate business entity with separate accounting, leases, and partnership tax filings.

Pre-mortem sale, cash to heirs

If heirs do not intend to keep the property, selling it while the parent is alive triggers a one-time capital gains hit but avoids a permanent property tax reassessment. A tax-deferred exchange under IRC §1031, “Exchange of real property held for productive use or investment” defers income tax but does not carry over the Proposition 13 base: the replacement property is assessed at its purchase price.

Primary residence compliance

To preserve the parent-child exclusion, the child must file a Homeowners’ Exemption (BOE-266) within twelve months of the transfer and reside in the property. Assessed value exceeding the prior base plus the $1 million exemption remains subject to reassessment.

Parental base-year transfer

Under R&TC §69.6, Proposition 19 lets homeowners over age 55, severely disabled individuals, or victims of natural disasters transfer their current Proposition 13 base assessed value to a replacement residence of any value anywhere in California — up to three times for the age and disability claimants, with no numeric limit for disaster victims. This benefit is limited to the parents’ lifetime and does not shield the next generation.

Grandchild routing under §63.2

Proposition 19 is implemented at R&TC §63.2 (added by SB 539, 2021); the older §63.1 regime of Propositions 58 and 193 governs only transfers on or before February 15, 2021. Under §63.2 a grandparent-to-grandchild transfer can qualify for the same family-home exclusion, but only if both of the grandchild’s parents are deceased at the time of transfer. One surviving parent disqualifies it entirely.