Understanding inheritance laws and taxes in California is crucial for anyone who finds themselves as a beneficiary of a property. However, these regulations and rates can get complicated quickly.
This post aims to simplify California's taxes on inherited property. It covers inheritance taxes in California, other relevant taxes, and the process of selling inherited property. It also provides clarity on where to find professional help in managing these taxes in the Golden State.
Is There An Inheritance Tax In California?
In California, beneficiaries inheriting assets, whether monetary or other types, are not subject to any state-specific inheritance tax. Furthermore, such inherited amounts are not considered taxable income under California's tax regulations. This exemption applies regardless of the value or type of inheritance received in the state.
What If I Decide To Sell My Inherited Property?
For Californians who inherit property, the main tax consideration arises upon selling that property. In such situations, the topic of having to pay capital gains taxes becomes relevant.
The capital gains tax only applies if the sale of the inherited property yields a profit, which is calculated as the difference between the selling price and the property's value at the time of the previous owner's passing. This concept is known as the 'step-up in basis'.
In California, the step-up in basis rule recalibrates the property's value to its market worth at the time of the original owner's death. This adjustment often results in a reduction of the potential taxable gain. Additionally, before applying capital gains tax, one can deduct expenses incurred for improvements to the property and sales-related costs from the profit made.
Understanding The Probate Process
In California, it is possible to sell a house that has been inherited, but it must first pass through a probate process. Probate is essentially the legal procedure that authenticates a deceased person’s will and facilitates the distribution of their property to beneficiaries.
The probate process involves several financial responsibilities. These include settling any outstanding mortgages on the property, paying property taxes, and clearing other bills. In cases where the property is mortgaged, an ‘Alienation Clause’ (sometimes referred to as ‘Due-On-Sale Clause’) may be activated. This clause requires the new owner, the inheritor in this case, to repay the full mortgage amount.
Most inherited real estate in California is subject to this probate procedure. The process can take as long as a year and a half, though this duration can vary depending on the specific state regulations, the number of beneficiaries, and other legal factors.
Exemptions To The Probate Process
In California, the probate process can be bypassed under certain conditions, ensuring a smoother transfer of property to heirs. One method to avoid probate in California involves utilizing a California Transfer-On-Death (TOD) Deed. This instrument allows a property owner to set up a deed that automatically transfers ownership of the property upon their passing.
By doing so, the property does not become part of the probate estate. In turn, this simplifies the process of transferring the property to the designated beneficiary and avoids the often complex and time-consuming probate process.
Another method involves inheriting a house in trust. If the previous owner transferred the house into a legal trust following their original purchase, a legal heir is entitled to inherit the property straight away. This arrangement circumvents the traditional probate process, making the transfer of ownership more straightforward and less time-consuming.
Taxes To Expect When Selling Inherited Property In California
While California may not impose an inheritance tax or an estate tax, there are still taxes associated with selling an inherited property:
Capital Gains Tax: Capital gains tax is applied on a stepped-up basis, meaning it's only relevant to any increase in the property’s value after inheritance.
Transfer Tax: This is a one-time charge paid by the inheritor during the transfer of ownership, with proceeds going to the local government.
Property Tax: In California, the basis for property tax is the acquisition cost of the real estate. Therefore, upon purchasing a property, its assessed value is set at the same amount as the purchase price. Subsequently, this assessed value experiences annual adjustments aligned with the rate of inflation, as indicated by the California Consumer Price Index changes.
How To Minimize The Capital Gains Tax Inherited Property In California
The tax implications for capital gains on inherited property are dependent on the duration of ownership. When such a property is sold within a year of acquisition, it incurs short-term capital gains tax rates. However, if the property is held for longer than a year, it becomes subject to the typically lower, long-term capital gains tax rates.
It's important to remember that capital gains tax is only levied on profits, so selling the property at a loss allows for the claiming of a deduction. Given that capital gains can significantly affect one’s overall tax burden, strategic planning is crucial when deciding to sell an inherited property. To lessen capital gains tax liability, consider the following strategies:
1. Turn The Inherited Property Into A Primary Residence: To dodge capital gains tax on an inherited property, consider making it a primary residence for at least two years. This approach leverages IRS rules that provide substantial tax relief for the sale of primary residences. By moving into and living in the inherited property for the required period, one can potentially eliminate their capital gains tax obligation.
2. Turn The Inherited Property Into An Investment Property: Converting inherited property into a rental property can help sidestep capital gains taxes. Using a 1031 exchange to acquire another investment property, individuals can potentially defer capital gains taxes indefinitely, thereby enhancing their real estate portfolio and income. This approach, however, is more suited for those prepared to dive into real estate investing. It demands commitment to managing rental properties and understanding complex tax laws, and may not be ideal for those reluctant to enter the real estate market.
3. Sell The Property Immediately: Minimizing capital gains tax on an inherited home can often be achieved by selling it swiftly. If the sale price is equivalent to the property's value at the time of inheritance, capital gains tax might be entirely avoided. Yet, quick sales can present challenges, including expenses like realtor fees, appraisals, and property improvements.
4. Disclaim The Inheritance: A direct way to avoid capital gains taxes on an inherited asset is to decline the inheritance. Opting out upon learning about inclusion in a will bypasses the tax complications and responsibilities tied to the asset. It's critical to recognize that disclaiming an inheritance is a final decision, and sometimes the emotional weight of rejecting a loved one's will could make this path more difficult compared to other strategies.
What If I Am Inheriting Property From A Non-California Resident?
California residents who inherit property or assets from a relative living in a different state may face inheritance tax implications depending on that state's tax laws. States that have inheritance taxes include:
Iowa
Kentucky
Nebraska
Pennsylvania
Maryland
New Jersey
Typically, if the spouse of the deceased person is the one inheriting the assets, they are exempted from inheritance taxes. However, in cases where these specific exemptions don't apply, the individual would be required to pay the inheritance tax as per the laws of the state where the deceased resided.
In each state, the rules and rates for inheritance tax are distinct and can differ greatly. It is crucial for individuals living in these states or inheriting assets from them to understand the specific inheritance tax regulations that may affect them and their heirs.
How Does Prop 19 Impact Taxes On Inherited Property In California?
California's recent passage of Proposition 19 (Prop 19) marks a significant change in the way property taxes and reassessments of property value are handled when properties are passed down to the next generation. Here's an overview of some critical considerations for property owners and their heirs:
1. Impact On Property Tax Reassessments: Under Prop 19, when a property is transferred from parents to children, it undergoes a reassessment for property taxes. The exception to this rule is if a child uses the inherited property as their primary residence and the property's reassessed value hasn't increased by more than one million dollars from its original value.
2. Changes From Previous Rules: Previously, parents could transfer their primary residence and up to one million dollars of other assessed property value to their children without creating the need for a reassessment. With Prop 19, this is no longer possible.
3. Effective Date: This new rule took effect on February 16, 2021, and applies to all property transfers to children occurring after this date.
Get Help With Handling Taxes On Inherited Property In California
At Burton Enright Welch, we understand that dealing with the nuances of taxes on inherited property in California can be a daunting task. The absence of a state-specific inheritance tax offers some relief, yet there are other significant tax considerations such as capital gains tax, property tax, and the impact of recent legislative changes like Proposition 19. Additionally, the factors like the probate process present further complexities that require careful navigation.
Our team of experts specializes in demystifying these complexities for our clients, considering the intricate interplay between federal and state tax regulations. We recognize that each inheritance situation is unique, and our guidance is tailored to your specific needs.
Additionally, we are diligent in staying up-to-date with the latest tax laws, including the intricacies of Prop 19, so that we can provide our clients with current and effective strategies when helping them with an inheritance. Together we can evaluate the approach that’s right for you and your property whether you are inheriting it from a fellow Californian or an out-of-state resident.
Your inheritance deserves careful and professional handling. At Burton Enright Welch, we are dedicated to helping you manage the tax implications of your inherited property with clarity and confidence. Our team is also equipped to help you craft an estate plan, addressing aspects like federal estate taxes and income taxes, should you be looking to leave behind a property of your own. Please reach out to our team and schedule your complimentary appointment.
