I receive a lot of questions about these 2 types of taxes. Rightfully so…they are complicated. Let me start off with a disclaimer: I am not a Accountant. I am not an Attorney. I cannot give either tax or legal advice (this will make our Attorney happy) but I am the one that gets all the questions so let me answer some of the basics…you should consult your Accountant and Attorney with the specifics of your situation.
Q. I have heard about a “stepped up basis” on my property. What does this mean?
A: There are other cases where this will apply but the main one I see is, that, upon the death of the first of the owners (husband or wife) of a house, the cost basis: the value that the IRS uses to determine what you paid for the house, “Steps up” to the market value of the house at their Date of Death (DOD). For example: M/M Homeowner bought their house in 1975 for $100,000…this becomes their “Cost basis”. Their house is now worth $2,000,000. If either Mr. or Mrs. passes away, the NEW “Cost basis” for their house would be $2,000,000.
Q: Why is the “Cost Basis” so important?
A: When you sell your house, Capital Gains taxes are essentially calculated as a percentage of the difference between the “Cost Basis” and the Sales Price. (You may also deduct “improvements” you have made to the house and you can deduct $250,000 per person or $500k per couple) From the example above, if the surviving spouse sells the house after the death of one of the owners for EG: $2,000,000, the capital gains would be zero: Deducting a cost basis of $2,000,000 from a sales price of $2,000,000.
Q: Why is this important?
A: There are multiple effects: 1. There may be a tendency for married couples to wait until one of them passes to essentially avoid the Capital Gains tax. This has the effect of reducing the inventory which tends to make prices rise. 2. The savings can be SUBSTANTIAL…just for example if your capital gains were at 35% and you sold your house for $2.000.000 while you both were alive, the tax would be about $490,000! ($2,000,000 sales price, minus the $100,000 cost basis minus the $500,000 exemption x 35%)
Q: What about Property Tax. How is it calculated?
A: Property tax is based on the price you paid for your home (Ad Valorem) and is charged at 1%. This number is allowed by Proposition 13 only to increase at up to 2% per year. Additional “parcel” taxes are added to that number. Parcel taxes or charged equally for every parcel regardless of value and are typically voted on for things like schools, sewers, vector control, etc. As a rough number, figure 1.25% of your purchase price in Property Tax per year, increasing about 2% per year.
Q: What happens if I sell my house to my kids?
A: There are provisions in the code that will allow your low Prop 13 tax basis to transfer to certain related family members. So, if you sell your house to your kids, they get to keep your low tax rate!
Owen Halliday is a REALTOR who manages the Sereno Group Real Estate office in downtown Los Altos. If you have a subject you’d like addressed in a future column, Owen can be reached at email@example.com or 650-492-0062.