Capital Gains Tax on Inherited Property

Inherited property receives a significant tax benefit under federal law that is often misunderstood by heirs. Rather than inheriting the original owner's cost basis, an heir generally receives a stepped up basis equal to the property's fair market value on the date of the decedent's death, or on an alternate valuation date if the estate elects one. For San Francisco, CA property that a parent or family member purchased decades earlier and held through enormous appreciation, this step up can eliminate most or all of the capital gain that would otherwise have been owed if the original owner had sold the property during their lifetime.

How the Step Up in Basis Works

Because California is a community property state, married couples who hold property as community property can, in many cases, receive a full step up in basis on both halves of the property when the first spouse dies, not just the deceased spouse's half, which is more favorable than the partial step up rule that applies in most non-community property states. This distinction matters significantly for surviving spouses in San Francisco, CA who inherit jointly held property, since it can eliminate built in gain on the entire property rather than only half of it. Heirs should confirm with a CPA or estate attorney how title was actually held, since the community property step up depends on specific ownership and titling facts.

Once an heir has inherited property with a stepped up basis, any future appreciation from the date of death forward is treated the same as appreciation on any other property. If the heir sells shortly after inheriting, there may be little or no taxable gain because the stepped up basis is close to the current fair market value. If the heir holds the property for a longer period after inheriting, new appreciation from that point forward will generate a taxable gain when eventually sold, calculated the same way as for any other owner.

Using a 1031 Exchange After Inheriting

Heirs who inherit San Francisco, CA property and want to reposition it, for example moving out of a single family home converted to a rental and into a different investment property type, can generally use a Section 1031 exchange going forward, provided the inherited property is held for investment or business use rather than personal use. The stepped up basis becomes the heir's starting basis for calculating any future exchange, and the exchange defers gain on appreciation that occurs after inheritance, not on the pre-death appreciation that the step up already eliminated. This combination, an inherited stepped up basis followed by an exchange into a different property, is a common strategy among Bay Area heirs who want to diversify a concentrated family real estate holding without triggering an immediate tax bill on the diversification.

We help heirs of San Francisco, CA property understand how the step up applies to their specific inherited asset, coordinate an appraisal or valuation to establish the stepped up basis where one was not already obtained through the estate, and evaluate whether a subsequent sale, a hold, or a 1031 exchange best fits the heir's goals for the property, always in coordination with the estate's attorney and the heir's own CPA.