Income Tax Advantage of Community Property — “Double Step Up in Basis” Rule

  1. Introduction
  2. Example of Single Taxpayer
  3. Example of Married Taxpayer in Non-Community Property State
  4. Example of Married Taxpayer with Community Property
  1. Introduction

A married person who owns assets with his or her spouse as community property in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) has a major income tax advantage over a married person who owns assets with his or her spouse but that are not community property.  This advantage results from the incongruous operation of the step-up in basis rule.  This rule creates one of the few, and perhaps only, tax advantages that a person’s estate receives upon his or her death and is available generally only to married couples in community property states.

  1. Example of Single Taxpayer

A terminally ill single person living in any state paid $10,000 (the taxpayer’s “cost basis”) for property 20 years ago (the property’s “holding period in the hands of the taxpayer”) that is presently worth $110,000 (the property’s “fair market value”).

  • If he/she sold the property today for its current value, he/she would realize a long-term capital gain of $100,000 (ie, amount realized – cost basis).
  • The gain would be subject to a maximum capital gains tax of 20% = $20,000.
  • If he/she died the next day, then as a result of Decedent’s death, the property would receive a “step up in basis” from its “cost basis” in Decedent’s hands prior to death to its then current value.
  • If the estate or the recipient of the property then sold it, no gain would be realized (ie, $110,000 amount realized – $110,000 stepped up basis), and no tax would be due — the $100,000 gain would be “forgiven.”
  1. Example of Married Taxpayer in Non-Community Property State

The step-up in basis rule gets more complicated when a married couple is involved.  Consider the same example as above but with married taxpayers in a non-community property state who hold title as husband and wife; each now owns one-half of the property.  This produces the same result as above if the couple sold the property today for $110,000: the couple realizes a $100,000 long-term capital gain and pays up to a maximum capital gains tax of $20,000, just like the single person did.

Now consider what happens if the husband doesn’t sell the property but dies the next day, and the wife inherits his half of the property and then promptly sells it for $110,000:

  • The husband’s half of the property receives a step-up in basis to $55,000, its value at the husband’s death.
  • The wife’s half of the property retains its original cost basis of $5,000.
  • The wife realizes a gain of $50,000 (ie, $110,000 fair market value – $60,000 ($55,000 from husband and $5,000 from wife) combined basis).
  • The wife pays up to a maximum capital gains tax of $10,000 = 20% of $50,000.
  1. Example of Married Taxpayer with Community Property

If the couple lived in a community property state, like Washington, and holds the property as community property, the income tax savings are maximized — no tax at all.  Consider the same example as immediately above but the property is community property under Washington law.  This produces the same result as above if the couple sells the property today for $110,000: the couple realizes a $100,000 long-term capital gain and pays up to a maximum capital gains tax of $20,000, just like the single person did.

Now consider what happens if the husband doesn’t sell the property but dies the next day, and the wife inherits his half of the property and then promptly sells it for $110,000:

  • Both halves of the property receive a step-up in basis to $55,000, its value at the husband’s death, so the basis in the property itself is stepped up to its current value = $110,000.
  • The wife realizes no gain.
  • The wife pays no capital gains tax.

Both halves of the community receive a stepped up basis — giving rise to what is known as a “double step up in basis.”  This tax result is due to the property being community property, available generally only to married couples in community property states.

Married couples in community property states
may obtain income tax savings at death
by holding their property as community property.