Trap for the Unwary (Married Couples Only—But Also Important for Single Individuals)

By Brad N. Baker, Partner

Many people only think about a “step-up” in basis when assets are inherited. (“Basis,” simply put, is the price you paid for an asset like a home. When you inherit a home, you can treat it as though you bought it at its fair market value as of the date the owner passed away.)

Because real estate in California has generally appreciated over time, most discussions about inheritance focus on this step-up in basis. For example, if Mom and Dad bought their home for \$125,000 and it’s worth \$2,000,000 when they pass away, you inherit it with a \$2,000,000 basis. If you immediately sell it for \$2,000,000, you would have no taxable gain—and therefore no income tax due on the sale.

However, the law says that inherited assets have their basis “adjusted” as of the date of death. That adjustment can be a step-up *or* a step-down. For example, if someone bought stock for \$100 but it’s worth \$50 when they pass away, the basis drops from \$100 to \$50—a step-down.

For married couples: if one spouse is expected to pass soon, sell any depreciated (“loser”) stocks or bonds *before* that spouse passes. Otherwise, you’ll “lose the loss,” meaning the surviving spouse won’t be able to carry forward those capital losses to offset future gains. (I can think of no exception to this advice.)

This rule only applies to married couples—only they can carry forward capital losses after a spouse’s death.

Please pass this tip along to your loved ones—it can make a meaningful difference.

There’s also another trap for the unwary, one that applies to both married couples and single individuals:

When you gift an asset to someone, the recipient (the “donee”) inherits your original basis. Using the earlier real estate example: if Mom and Dad bought a home for \$125,000 and gifted it to you during their lifetimes, your basis would remain \$125,000—there’s no step-up. The lesson here: sometimes it *is* wise to “look a gift in the mouth.”

From an income tax perspective, it’s almost always better to inherit appreciated property than to receive it as a lifetime gift.

There’s also no estate tax advantage to gifting that same \$2,000,000 residence with a \$125,000 basis. Such a gift would use \$2,000,000 of your estate tax exemption based on the fair market value at the time of the gift—not your basis. In other words, you get the worst of both worlds: no step-up and a large exemption used.

I hope you find this information helpful.

DISCLAIMER: This article is provided for informational purposes only and does not constitute legal advice. The information contained herein should not be relied upon as a substitute for legal counsel. This article provides general information about the law, which may differ by jurisdiction and is subject to change. No attorney-client relationship is formed by reading this article or by contacting our firm through this website. Readers should consult with qualified legal counsel before taking any action based on this information.