Dear Liz: We are a heterosexual couple who are registered domestic partners in California. We have owned our primary residence for decades. Obviously, its value has increased and is well past the $500,000 home sales exemption limit for couples.
When one of us passes away, how is the basis and the appreciation of the residence calculated for federal and state taxes? Does the step-up basis come into play for both federal and state taxes when calculating capital gains? We do not have any children and are leaving the bulk of our estate to charity.
Answer: California offers the valuable double step-up in tax basis to registered domestic partners, but the federal government does not.
In most states, one half of a couple’s jointly owned property gets a new value for tax purposes when the first partner dies. This step-up in value eliminates capital gains taxes on any appreciation that happened during the deceased partner’s ownership.
In community property states, however, both halves of jointly owned property can get the step-up in value when the first spouse dies. California generally treats registered domestic partners the same as married couples, but IRS Revenue Ruling 2013-17 and Regulation 301.7701-18(c) specify that “marriage” and “spouse” do not include registered domestic partnerships for federal tax purposes, according to Wolters Kluwer Tax & Accounting.
Let’s say you bought the house for $300,000 in the 1980s, invested $100,000 in upgrades over the years and it’s worth $2 million today. The current tax basis would be $400,000 (the sales price plus the upgrades). That’s the amount the two of you would subtract from the sales price to determine the potentially taxable capital gain. You could exempt $500,000 of the home sale proceeds ($250,000 per owner) since you’ve owned and lived in the property at least two of the past five years. That leaves a taxable gain of $1.1 million.
If one of you died tomorrow, only half of the property would get stepped up to the current market value for federal tax purposes while the other half would retain its $200,000 basis for a total basis of $1.2 million. For state tax purposes, both halves would get the step-up so the new tax basis for state taxes would be $2 million.
Something else to consider: a federal law allows the full $500,000 exclusion for surviving spouses if they sell the home within two years of the death. That provision is not extended to registered domestic partners.
As you can see, a marriage certificate could make an enormous difference if the survivor wanted or needed to sell the home after the first death.
Marriage confers a number of other benefits under federal law. A spouse can receive Social Security spousal and survivor benefits, for example, but registered domestic partners aren’t eligible for benefits on a partner’s earnings record. Spouses also have special rights with IRAs and employer retirement plans, such as being able to treat an inherited IRA as their own. Non-spouse beneficiaries, including domestic partners, generally must empty the accounts within 10 years.
Your mileage may vary, but the benefits are numerous and valuable enough to make marriage worthwhile in many cases. Please talk to your tax pro and estate planning attorney for individualized advice.
