The surprising tax advantage for married couples in California

You don’t often hear about a tax advantage to living in California. Especially one that other states don't offer. Here’s a scenario to explain how it works.

Let’s say Linda and Ray bought their house in the Valley in 1994 for $200,000, which felt like a lot of money at the time (and it was). When Ray passed away years later, the house was worth about $1.4 million. Three years after that Linda decided to sell and move closer to her daughter. Now, the amount of tax due on that home sale is going to depend on the wording of the original deed, which she likely hasn’t checked since escrow closed. 

Photo by Maurice Williams on Unsplash 

Understanding tax basis and the mechanism of step-up resets

When you sell your house, you pay tax on the gain, which is the sale price minus what the tax code calls your “basis.” The basis starts at what you paid for the house and goes up when you make major improvements (like a new kitchen, for example). For Linda and Ray, let’s keep the math simple and say that number is $200,000.

When someone dies, the property they owned generally gets a new basis equal to what it's worth on the date of death. Whoever ends up with it is treated as if they bought it at that value, so the growth during the owner's lifetime is never taxed. This is called a step-up in basis, and it's one of the more generous rules in the tax code. (The reset can go down as well as up if a property lost value, though that's rare.) When the first spouse passes away, the key issue for a married couple is determining how much of the property qualifies for a basis adjustment, which comes back to how ownership is titled.

Why California couples can get the whole house reset

In most of the country, a married couple owns their house as two halves. When one spouse dies, that spouse's half gets a new basis and the surviving spouse keeps the old basis on their own half. So, in the Linda and Ray example, if they were in one of these other states, the basis would step up half way between $200,000 and $1.4 million to a new basis of $800,000. 

California is one of nine community property states, along with Arizona, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Federal tax law treats community property as if each spouse owned 100% of the property (which is a total of 200%, which doesn’t really make sense, but that’s how the law works). When either spouse dies, the entire community property asset gets a new basis, including the half that belongs to the surviving spouse.

Community property gets a new tax basis on the whole house when the first spouse dies. Joint tenancy or tenants in common between spouses gets a new basis on half.

Living in California isn't enough on its own, though. Plenty of married couples here took title as joint tenants, since joint tenancy is familiar and it does keep the house out of probate when the first spouse dies. Technically, for tax purposes, a house held by spouses as joint tenants is treated as belonging half to each of them, so only the half that belonged to the spouse who died gets the new basis. 

California makes this a little more complicated. In a 2020 case called In re Brace, the California Supreme Court looked at a couple who bought property during their marriage with shared money after 1984. The court held that writing "joint tenants" on the deed wasn't enough by itself to stop it from being community property. So a surviving spouse with a joint tenancy deed may be able to show the house was community property all along and claim the full step-up. That's an argument you might win, but you'd be making it with old bank records, maybe in court and maybe to the IRS, at a time when you'd rather be doing almost anything else. It's a lot simpler when the deed itself says community property.

What the difference looks like in dollars

In our scenario, let’s say Ray dies with the house worth $1.4 million and Linda sells it later for the same price.

If the house was community property, Linda's basis in the whole house is $1.4 million. She sells it for $1.4 million, and there's no gain to tax.

If the house was in joint tenancy, only Ray's half gets the new basis. His half now has a basis of $700,000. Linda's half keeps her share of the original price, which is $100,000, so her total basis is $800,000. She sells for $1.4 million and has a $600,000 gain.

She can exclude part of that gain because it was her home. A single person can exclude up to $250,000 of gain on the sale of a main home, and a surviving spouse who hasn't remarried can use the full $500,000 married exclusion if she sells within two years of the death. Linda waited three years, which is what a lot of people are told to do after losing a spouse (and it's good advice, for almost everything except this). So she excludes $250,000 and has $350,000 of taxable gain. California taxes capital gains like any other income, with no lower rate, so she pays state tax at her regular rate on top of the federal tax. Depending on her other income, the combined bill could be roughly $80,000 or more. If she'd sold within two years, the taxable gain would have been $100,000 instead, which is better, but it's still a tax bill that a community property deed would have avoided.

A surviving spouse can exclude up to $500,000 of gain on the sale of the home within two years of the death. After two years, the limit drops to $250,000.

Three ways to hold title

Married couples in California usually hold title to a house together in one of three ways, and each are distinct. Joint tenancy passes the house to the surviving spouse automatically, without probate, but only half of it is sure to get the new basis. Plain community property gets the full step-up, and each spouse can leave their half to anyone they want by will. The house doesn't pass on its own, though, so the surviving spouse often needs a short court petition to put it in their name. The third option, community property with right of survivorship, has been available on deeds signed since July 1, 2001. It combines the automatic transfer of joint tenancy with the full step-up of community property. None of the three triggers a property tax reassessment when the first spouse dies.

For a lot of couples, community property with right of survivorship is the best of both. It isn't right for everyone, though. If one of you wants to leave your half of the house to children from an earlier marriage, for instance, a survivorship title works against that, and plain community property or a trust might fit better.

Married couples in California can hold title as community property with right of survivorship on deeds signed on or after July 1, 2001.

Changing a deed that says joint tenancy

If your deed says joint tenancy and you'd rather it didn't, the solution is usually a new deed from the two of you, to yourselves, as community property. A transfer between spouses doesn't trigger a property tax reassessment in California, so your Prop 13 tax base shouldn't change. A new deed does more than update paperwork, though. Under Family Code section 852, a change in who owns what between spouses has to be in writing and say so clearly. Calling a house community property also matters for more than taxes. If one of you put separate money into the house, like an inheritance or savings from before the marriage, the change can affect what each of you would get back if the marriage ended. That's a conversation to have with a lawyer before either of you signs anything. It's probably the best reason not to do this with a form you found online.

A deed between spouses in California does not trigger a Prop 13 property tax reassessment.

If your house is in a living trust, the deed will name the two of you as trustees and the question moves into the trust itself. Your trust documents may say whether the house is community property, and it's worth checking that they do.

Checking your own deed

Your original grant deed was mailed to you after it was recorded, so it may be in a folder with your closing papers. If you can't find it, your county recorder sells copies. In Los Angeles County that's the Registrar-Recorder/County Clerk, and in Orange County it's the Clerk-Recorder. You don't need to pay one of the companies that send official-looking letters offering to get a copy for you.

Look near the top of the first page for the line that says who the property is granted to. Right after your names, you'll see how you hold title. Something like "husband and wife as joint tenants" means joint tenancy (newer deeds often say "a married couple" or "spouses"). "As community property" or "as community property with right of survivorship" means you're already set up for the full step-up. If the deed names the two of you as trustees of a trust, the answer is in your trust documents. If it says something else, or nothing at all, that's worth asking about too.

If you find the words "joint tenants" after your names and want to talk through whether to change them, we're glad to look at it with you.