Disclaimer: I am not an attorney and this article is not intended as a substitute for advice from the appropriate legal, zoning, financial, construction and/or tax professionals. This information is provided for educational purposes only and is made without warranties or representations
One of the indelible facts of life is that, sooner or later, it ends. Each and every one of us will experience loss at some time in our lives, and in many cases, the social and financial repercussions of that loss can be felt for a long time. For some people, an inheritance is an unexpected windfall. For others, it’s a hassle to deal with.
If you live in California and you inherit a piece of property, one of your biggest questions is likely going to be what kind of financial repercussions it will have. Because nothing in life is easy; it’s never as simple as just selling the house, taking the money, and doing what you want with the inheritance. Taxes put a damper on any plans, and the burden of even knowing what taxes apply can be surprisingly difficult.
If you’re concerned about having to pay a capital gains tax on inherited property, it’s probably worthwhile to learn what a capital gains tax is in the first place. After all, many of the people concerned about it only know about it from half-remembered advice heard on the radio, talking points across elections, and other half-informed situations.
Luckily, a capital gains tax is a pretty simple concept.
Capital gains taxes are taxes paid on the profit of the sale of an investment.
It doesn’t matter what the investment is. Capital gains applies to stocks, bonds, investment accounts, commodities, and property sales- anything you’ve owned for over a year. If you’ve owned it for less than a year, capital gains don’t apply; instead, the income generated by the sale is simply considered just that: income. It’s taxed as part of your income according to your income bracket.
Capital gains taxes are relatively easy to calculate. Each year, the IRS puts out a chart of the capital gains tax brackets, and it’s a progressive tax just like income taxes. That means you pay one rate for the first chunk of value, another rate for the second chunk of value, and a third rate for the remaining value. In the case of capital gains, those three rates are 0%, 15%, and 20%. For 2023, here’s what the chart looks like for someone filing as single.
Note that these are the 2023 values and are just the values for filing as single. Your filing status changes the values, and each year, the IRS adjusts them for inflation.
If you inherited a run-down piece of property in the middle of nowhere and sold it for $40,000, the whole of your gains falls into the 0% tax bracket, and you don’t end up paying capital gains on it. If you inherit property in the middle of downtown L.A. and sell it for a few million, your tax situation becomes much more complex.
There’s a lot more to the story with capital gains as well. To hit some bullet points:
When you inherit property, you don’t necessarily inherit a huge tax bill.
Capital gains taxes are a tax on the profit from the sale of an investment. If you buy something for $1,000, hold it for ten years, and sell it for $10,000, the profit is $9,000, and that’s what you would be taxed on. (Set aside that this falls into the 0% tax bracket for the moment.)
Well, what about a property that you inherited? You didn’t buy it, and you may not even know what its purchase price was. Rather than force you to find or calculate what the value may have been, which can be extremely complicated, California applies what is called a step-up in basis.
Here’s what I had to say:
“A ‘step-up in basis’ in real estate refers to a change in the tax cost basis of an inherited property. When someone inherits a property, the value of the property for tax purposes is reset to its current fair market value. This means that the new owner’s tax basis in the property is “stepped up” to its value at the time of inheritance rather than the original purchase price paid by the previous owner.”
Rather than charge you taxes on the difference between the original purchase price and the current value of the property, the “purchase price” is stepped up to its current market value. If you sell immediately, you sell for that same market value, meaning your profit is $0 on paper and triggers $0 in taxes.
No, but they still tax gains.
Specifically, California does not have a capital gains tax. Capital gains taxes are generally lower than an equivalent income tax, which encourages longer-term investments over short-term investments. This is how federal capital gains taxes work and why they don’t start up until you’ve owned an investment for at least a year.
“California does not have a lower rate for capital gains. All capital gains are taxed as ordinary income.”
In California, this means that if you inherit property and sell it, the resulting profits are taxed as income.
California also does not have a specific inheritance tax.
Inheriting a property is one thing, but sometimes estate planners get into the weeds with ways to try to circumvent estate taxes, inheritance taxes, or other taxes that would apply to the transfer of assets upon death.
Wills and Trusts are examples of these, with their own rules, exemptions, loopholes, and changes in tax policy that you’ll almost definitely need a tax professional to help you navigate. I’m not a tax professional – I just help people buy and sell commercial real estate – so please don’t take my advice as gospel.
A big part of capital gains taxes is determining what you plan to do with the assets you inherit.
When it comes to real estate, you generally have three options, depending on the kind of property it is.
Your first option is to keep the property and move in. Whether you’re moving into a unit in an apartment complex your parents owned or moving into a childhood home, by occupying the property, you can begin the process of converting it into owner-occupied property. This takes at least two years of occupation, wherein it’s your primary residence, so you can’t just designate an apartment to be yours but never spend time there and have it count.
Occupying the property has a few benefits. For one thing, maybe the property is in a better or more desirable location for you than your current home; occupying the property gives you those benefits of convenience. More importantly, occupying the property gives you a break when you eventually go to sell the property if you do. You don’t have to, of course, but if you choose to sell at the peak of a real estate value surge, you can take advantage of that added bit of assistance.
On the other hand, you can only have one primary residence. If you’ve inherited a variety of different properties in a portfolio and you want to sell them, you can only designate one as owner-occupied every two years. That turns the liquidation of the portfolio into a much more lengthy process and probably isn’t actually worthwhile.
Your second option is to keep the property as part of your own portfolio and rent it out to tenants. This gives you the income generated by the property but also leaves you responsible for property taxes. Moreover, recent changes to California’s tax code, specifically Proposition 19, can leave you responsible for a fairly significant property tax bill right off the bat. For some people, and in some situations, this can be a significant deal-breaker.
If the increase in property taxes is something you can handle, and the income from the property, even with any deferred maintenance, is still worthwhile, the calculations may work out to make it a great investment property to keep around. On the other hand, there are plenty of reasons why a property may not be a viable investment right now, including the dramatic decrease in demand for office space we’ve seen since the rise of COVID-19.
If the investment just isn’t right for you, the third option is, of course, to sell the property. Selling the property nets you the immediate windfall without having to worry about property taxes or, if you sell quickly, estate/capital gains taxes. If you hold onto the property for over a year, though, you’ll be stuck paying the capital gains taxes on the property, so you need to make the decision quickly.
Any of them. It’s impossible for me to tell you which of the three choices is the right way to go because it depends heavily on your personal situation. Someone inheriting a $250,000 single-family home on the outskirts of a city is in a very different situation from someone inheriting a $10,000,000 commercial park, which is all complicated by where the person inheriting the property lives. There’s simply too much variation to make a determination; you’ll have to decide for yourself.
That said, I did a rundown on the pros and cons of renting or selling a property in this article if you want to read a bit deeper into the options.
The act of inheriting anything, be it money or property, has the potential to trigger a tax on the person inheriting it. This is called an inheritance tax. There’s no federal-level inheritance tax, but some states – Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania – do have them. Since none of those are California, I’m not really concerned with digging into the details of such a tax.
Note that estate taxes, which are taken out of the estate before you receive it, are a different kind of tax. These generally do apply at the federal level, but the first near-$13,000,000 is exempt from them, so realistically, most estates are never going to see these taxes. Most of the time, you won’t have to worry about it.
If you’ve recently come into a portfolio of real estate – whether it’s a single building or parcel of land or a full real estate investment portfolio involving multiple properties – you stand to gain a significant windfall. Even at worse, if the value of the property drops, you end up paying nothing on the taxes and simply receive the money from the sale.
Note that capital losses are their own beast and require specific qualifications to meet the usage requirements. This is to avoid exploiting capital losses by “selling” a property to a close family member or partner.
In any case, if you have commercial properties and you want to divest yourself of them, I’m your man. As California’s top commercial real estate agent, I’m uniquely positioned throughout the state to get you the best possible deal on the properties you have to sell. Maximize your windfall! Moreover, if you want to turn around and reinvest in different properties, I can help with that as well. All you need to do is reach out, and we can get started whenever you’re ready.
Erik Egelko is a veteran of the commercial real estate business with a specialized focus on Investment Property Sales. In 2021 and 2022, Erik was the #1 ranked Broker in California for one of the largest CRE Firms as well as ranked in the Top 1% of brokers nationwide. He has extensive experience in a variety of asset types including: Retail Shopping Centers, Medical Office Buildings, Industrial Properties, and Multifamily Apartment Complexes. Over the course of his career, Erik has closed over $100,000,000 of commercial property sales throughout Southern California.