In California, separate property generally includes assets acquired before marriage, assets received by gift or inheritance by one of the spouse’s during marriage, and certain assets acquired with separate property funds.

When an individual dies owning separate property, the property generally receives a step-up in basis to its fair market value as of the date of death, provided it is included in the deceased owner’s estate for federal income tax basis purposes.

This rule applies whether the property passes to a surviving spouse, children, or other beneficiaries.

Example: Separate Property Inherited by a Surviving Spouse

Suppose a husband purchased a home before marriage for $400,000. The property remained his separate property throughout the marriage.

At the time of his death, the home’s fair market value is $1,200,000.

If the husband leaves the property to his wife through his living trust, the wife’s new cost basis generally becomes $1,200,000.

If she later sells the property for $1,250,000, her capital gain would generally be $50,000 before applicable adjustments, rather than the $850,000 appreciation measured from the husband’s original purchase price.

The fact that the property was the husband’s separate property does not prevent it from receiving a step-up in basis at his death.

What Happens When the Surviving Spouse Owns Separate Property?

A different result occurs when the surviving spouse owns separate property, and the other spouse dies.

Suppose a wife purchased an investment property before marriage for $350,000. The property remained her separate property and is now worth $1,000,000.

If her husband dies, the wife’s property generally does not receive a step-up in basis merely because of his death.

Because the property belongs entirely to the surviving wife and is not included in her husband’s estate, its adjusted cost basis generally remains unchanged.

The wife may receive a basis adjustment when she eventually dies, assuming the property qualifies under the applicable federal tax rules.

This distinction is particularly important for married couples who own substantial assets separately.

Separate Property vs. Community Property: Why the Difference Matters

California is a community property state, and federal tax law provides a particularly favorable basis adjustment for qualifying community property.

When one spouse dies, both halves of qualifying community property generally receive a basis adjustment to fair market value, even though only one spouse has died.

By contrast, when spouses own property as separate property, the death of one spouse generally produces a basis adjustment only for property or ownership interests attributable to the deceased spouse.

Example: Community Property Compared to Separate Property

Assume a married couple owns a rental property originally purchased for $500,000. At the first spouse’s death, the property is worth $1,500,000.

Scenario 1: The Property Is Community Property

If the property qualifies as community property under California law and the applicable federal tax requirements, the entire property’s cost basis generally adjusts to $1,500,000 at the first spouse’s death.

Scenario 2: The Property Is Owned as Separate Property by the Surviving Spouse

If the rental property belongs entirely to the surviving spouse as separate property, the death of the other spouse generally does not change its cost basis.

The surviving spouse retains the property’s existing adjusted basis, which may result in substantial capital gains taxes if the property is sold.

Scenario 3: Each Spouse Owns a Separate One-Half Interest

If each spouse owns a separate 50% interest in the property, rather than holding it as community property, the deceased spouse’s one-half interest generally receives a basis adjustment.

The surviving spouse’s separate one-half interest generally retains its existing adjusted basis.

The resulting combined basis may therefore be substantially lower than the basis available if the entire property had qualified for the community property adjustment.

Does Putting Separate Property Into a Living Trust Change Its Cost Basis?

Transferring separate property into a revocable living trust generally does not change its cost basis or automatically convert it into community property.

For example, if a wife transfers her separately owned investment property into her revocable living trust, the property generally retains its separate property character unless the spouses take additional legally effective steps to change that characterization.

Upon the wife’s death, the property may qualify for a step-up in basis even though it is held in the trust.

However, merely placing separate property into a joint living trust does not necessarily make it community property.

The legal characterization of the asset, rather than simply the name of the trust, is critical in determining the applicable basis adjustment.

Should Married Couples Convert Separate Property Into Community Property?

Because California community property may qualify for a full basis adjustment at the first spouse’s death, some married couples consider converting appreciated separate property into community property.

This strategy can offer significant potential income tax benefits, particularly when the couple owns highly appreciated real estate or investments.

However, converting separate property into community property is not always advisable.

Such a conversion can affect ownership rights, division of property in the event of divorce, creditor exposure, and the ultimate disposition of assets upon death.

For individuals entering a second marriage, bringing substantial separate assets into a marriage, or wishing to preserve property for children from a prior relationship, maintaining separate property may be more important than obtaining potential tax benefits.

Additionally, California has specific legal requirements for valid transmutations of marital property.

Before changing the characterization of an asset, married couples should carefully evaluate both the estate planning and potential tax consequences.

Does the Step-Up in Basis Eliminate All Capital Gains Taxes?

Not necessarily.

A step-up in basis generally eliminates capital gain attributable to appreciation occurring before the deceased owner’s death, but it does not eliminate taxes on appreciation occurring afterward.

Other considerations may also affect the tax consequences, including depreciation adjustments, selling expenses, applicable exclusions, and the type of asset involved.

Certain assets, including traditional IRAs and other forms of income in respect of a decedent, generally do not qualify for a step-up in basis.

For rental properties, a basis adjustment can be particularly valuable because the new basis may also affect future depreciation deductions, subject to applicable tax rules.

Estate Planning for Separate Property in San Diego

For California married couples, the distinction between separate property and community property can have significant consequences for both estate planning and future capital gains taxes.

A properly structured living trust can help ensure that assets pass according to the owner’s wishes while preserving their intended property characterization.

However, creating a living trust alone does not guarantee the most favorable income tax treatment. The ownership and characterization of each asset should be evaluated as part of the estate planning process.

If you own separate property, inherited assets, or appreciated real estate, consulting with an experienced estate planning attorney in San Diego can help you understand how your estate plan addresses these assets.

Our estate planning office assists individuals and families with living trusts, separate property planning, and estate planning in San Diego, Carmel Valley, Del Mar, La Jolla, and surrounding communities.

Whether you are looking for a living trust attorney in Del Mar or an estate planning attorney in Carmel Valley, understanding how the step-up in cost basis applies to your assets is an important part of planning for the future.