The “Double Step-Up” Advantage

In a community property state such as California, there is something called a “step-up in basis.” It’s considered a loophole for those inheriting assets that carry large capital gains. With a step-up in basis, the original cost basis of the asset is removed, and it’s replaced by the current market value. Thus, the capital gain is reduced for whoever is inheriting the asset. This change occurs when the asset is transferred—usually when the decedent dies—or in the case of a married couple, when the first spouse dies.

There is also what’s known as the “double step-up in basis” that occurs when the surviving or second spouse dies. The asset that is inherited receives a second “step up.” Thus, in a state with community property laws, the inherited asset gets stepped up twice—once for the surviving spouse, and then again for the person who becomes the final beneficiary of the asset. The double step-up can greatly reduce the amount the final beneficiary must pay in capital gains.

Why You Need to Talk About Community Property With Your Spouse

No matter how well you and your partner get along, you may still have different ideas about what should count as community property and what should be considered separate property.

You may want to discuss:

  • Which assets should be considered separate, and which should be considered community?
  • If one or both spouses have children from a prior marriage, would either spouse want to gift any assets to those children after the first spouse dies?
  • Similarly, what would happen if one spouse passed on the family home to their step-children, and those step-children needed to sell it? Where would the surviving spouse live?

Depending on your circumstances, you may wish to recategorize some community properties as separate properties. Couples often do this if:

  • Both partners have children from prior relationships and wish for their respective children to receive all or most of their individual assets
  • One spouse acquired an object of unusual value or sentimental importance after value and wishes to bequeath it to someone else upon death
  • One partner is paying for a home, vehicle, or other asset and wishes to retain full interest in that asset

The last example is particularly important because separate properties can sometimes become community properties. For example, one spouse may have purchased a home years before marriage. But if there is a mortgage on the property, the new spouse will acquire an ownership interest equivalent to 50% of every post-marital mortgage payment, even if they are not contributing any money themselves.

How to Take an Asset Out of Community Property 

You cannot obtain any automatic exemption from community property law. However, California’s legal system understands that married couples may wish to make exceptions for certain assets.

If you wish to categorize specific community properties as separate properties, you may sign either a premarital or post-marital agreement. While such agreements need not be legally complex, they must be clear and unambiguous. Furthermore, each partner must have an attorney review their agreement, unless they insert a clause waiving their right to attorney review.

In general, it is best to have an attorney review your agreement, since any ambiguity or diversion from California state law could be grounds for a legal challenge after a spouse’s death.

Community property can present significant tax advantages, but it can also complicate relationships and inheritances. Before purchasing a home or writing a will in California, it’s important to consider whether your preferred ownership arrangement is compatible with your estate plan.

 

Philip J. Kavesh
Helping clients with customized estate planning guidance and trust & estate administration for over 44 years.