What is the Probate Tax?
As a general rule there are no taxes for going through the probate process. However, as a result of probate, there are 3 types of taxes you may be subject to: 1) inheritance taxes, 2) capital gains taxes, and 3) property taxes. Due to changes in the probate inheritance tax structure, most find that only property taxes are of significance in the probate and inheritance tax landscape.
Although there are special rules for non-citizens, which we won’t cover here you are generally excluded from paying inheritance taxes if you inherit less than $5 million for one person. Couples can usually double this to be excluded if they inherit less than $10 million with a properly draft family trust. That means there is no probate inheritance tax for about 90% of the American population.
Capital Gains Taxes
Capital gains taxes are applied when a person profits from an increase in value of assets such as stocks, bonds, or real estate. We’ll use real estate in our discussion of capital gains taxes and probate.
One of the major benefits of inheriting property is even if that property has increased in value from the date of purchase to the date of death, that appreciation is not taxed. This is called a “stepped up basis” from which to calculate capital gains taxes.
To illustrate this we’ll use the example of Mom and Dad passing away and leaving their house to their children. When Mom and Dad first bought their house, they may have paid hundreds of thousands of dollars less than what it was worth when the last parent died. Let’s suppose that the parents’ house was originally purchased for $20,000 and at the time of the last parent’s death was worth $300,000. Had the parents sold the house while they were alive, they would be subject to a capital gains tax on the difference between $20,000 and $300,000. The purchase price, $20,000 is used as the basis for these capital gains tax calculations. [Note that typically there is a $250,000 one-time capital gains exclusion for real property during a person’s lifetime, but that will not be discussed here.]
Now, the question is, is the capital gains tax calculated the same way after the children receive the property through the probate process as it would be for a lifetime gift? The answer is no. The basis for the house through probate is “stepped-up” to $300,000. Because you use the $300,000 value and not the $20,000 value, there is typically no appreciation to be taxed and the children will not pay a capital gains tax for that time period. For a lifetime gift, you may be able to value the real property as of the date of the gift, but that is a long discussion, which is not appropriate here. The important issue is, for a lifetime gift, you do not get the stepped-up basis like you would when inheriting the property.
Real Property Taxes
The most significant taxes resulting from probate in California are on real property. The rates and rules for these taxes are driven by California Proposition 13. Typically, a transfer to a child is tax-free under Proposition 13 but, it is typically not free to a grandchild. Some local assessors take the position that if one child buys out another as part of the probate process of the parents’ house, the one who buys out is not tax free. Under Proposition 13, there are a series of exemptions but those exemptions can be a trap for the unwary. Because of the traps built into Proposition 13, it is wise to contact experienced counsel to navigate property taxes in California.
Please call (510) 724-2020) or contact us with your California probate tax questions if you are in one of the following Bay Area locations: San Francisco, Berkeley, Albany, Pinole, Crockett, Martinez, El Sobrante, El Cerrito, Vallejo and Richmond. With over 30 years of experience, we can help you navigate the probate process.