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I’VE WRITTEN BEFORE about harvesting tax losses and using them to offset the gains from selling other investments. We have a bit of a sprawling portfolio, with numerous small positions and lots of embedded capital gains.
Gradually harvesting gains would simplify the portfolio and make it more tax-efficient. And if we do so during these early retirement years, while our income is low, and if we can partially offset those gains with realized losses, we should be able to harvest gains at low rates—and perhaps even pay 0% in capital gains taxes.
But should we sell? Lately, I’ve come to realize that—from a long-term tax perspective—it may be better to leave the gains alone, especially since we’re residents of a community property state. Living in such a state may also argue for combining individual taxable accounts into joint accounts.
There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. The other 41 are separate property states. In a community property state, all property accumulated during a marriage is considered the property of both partners. This is a key consideration in a divorce and the resulting division of assets. But it also has important implications for investment and estate planning.
As many readers know, when the owner of property dies, that owner’s heirs get a step-up in cost basis on inherited property that’s held outside a retirement account. For example, if I bought a vacation home for $300,000 that’s worth $500,000 today, I would have a $200,000 capital gain if I sold it. Likewise, if I bought 1,000 shares of ABC company at $100 a share and they’re now at $150, I’d have a capital gain of $50,000 if I sold today.
But if I wake up today planning to sell but instead die before doing so, my heirs inherit the house and the stock at today’s value. Result? When they sell, their cost basis will be today’s value, not my original cost basis. This step-up means the gains between my purchase and my death go untaxed. As you can imagine, on assets held for many years, this can be a huge tax savings.
The above is true regardless of whether one lives in a community property state or not. Here’s where the state of residence comes into play: In a community property state, assuming my heir is my spouse, the step-up occurs not only on property owned by me, but also on the full value of property we own jointly.
How does this work? Let’s say that, in addition to the shares of ABC company I own in my taxable account, my spouse owns shares of XYZ company in hers. Since those shares are in her own individual account, she gets no step-up on XYZ when I die. Instead, I would get a step-up when she dies. But let’s say we held both these stocks in a joint account. In most states, the step-up in the joint account would be limited to 50% of each position. But in a community property state, the surviving spouse would get a full step-up on both holdings.
In the individual taxable brokerage accounts that my wife and I own separately, we have significant capital gains, so—from an estate planning perspective—it makes sense to combine them into a joint account or to change the account registration on both accounts to make them joint. That way, when either of us dies, the survivor gets a full step-up on everything outside our retirement accounts. It could also simplify the portfolio a bit.
What are the possible downsides of combining accounts?
For us, combining accounts seems like a good idea for the larger step-up alone. If we did so, we might choose to forgo realizing capital gains during our low-income years, knowing that there will eventually be a step-up on everything. Instead, we could use these low-income years to maximize Roth conversions.
Michael Perry is a former career Army officer and external affairs executive for a Fortune 100 company. In addition to personal finance and investing, his interests include reading, traveling, being outdoors, strength training and coaching, and cocktails. Check out his earlier articles.
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Wow, great article, I live in CA so the 100% step up in basis on all jointly held assets upon the first of our deaths is very important information for my wife and I, thanks for publishing it!
Somewhat related – make sure you have a will. In some states, the surviving spouse does NOT automatically inherit the other half of the state. In one case I know of, assets went to the parents of the deceased. That did not go well for family relations….
As well as up to date beneficiary designations, which come into play before a will. Thanks for reading and commenting.
Good topic. I would encourage those with events or planning that could change the tax basis of assets acquired by events other than the original purchase to read to the current version of IRS Pubs 550 and 551 before taking action. Actual tax law and regulations are authoritative but are often unreadable where IRS Pubs are more readable but have been ruled as not authoritative in tax disputes.
As noted in Andrew’s link – the basis of property held by a decedent is adjusted (“stepped”) up or down to its fair market value as of the date of the decedent’s death or as of the alternative valuation date pursuant to an election under IRC Sec. 2032 – so the basis adjustment is a two way street that the adjustment to tax basis could be a increase or a decrease to adjust to the DOD FMV amount. Also note that IRC 2032 allows an election to decrease (but not increase) the FMV at the date six months after the DOD which is typically useful only if the decedent has a large estate subject to estate taxes. See https://www.law.cornell.edu/uscode/text/26/2032
In regard to Richard’s comment on the step up in basis for real property I would add that, unlike public stocks, a timely qualified appraisal as of the date of death may be necessary to establish new tax basis. This appraisal may be of particular importance for the second to die spouse of real property originally acquired by a couple and owned JWROS if the real property will not be subject to actual sale until the second death.
Also note that in addition to retirement accounts certain other assets do not get a basis adjustment at death like the interest I have earned on my I bonds or undistributed income on annuities.
William, thanks for the perspective and all the additional good for thought and resources there.
Good info – too bad it is often valuable for so many people these fays.
After 55 years married my wife and i aren’t going anywhere – well divorce in any case.
Your tip on the step up on an inherited vacation home was especially helpful. I knew about the step up on investment cost basis, but didn’t dawn on me the vacation was included.
That takes away a big concern i had.
Dick, glad you found it helpful. The article Andrew shared gets a bit deeper into real property than I endeavored to, as I was focused on investment accounts. Probably worth a look.
Michael, thanks for an important article. One thing, though—and I should first say I’m no tax lawyer—my understanding is that whether marital assets are held in a joint account or separate accounts is not what determines if they are community property.
For couples living in community property states, like Texas where we live, property is presumed to be community property unless proven to be separate property (e.g., acquired via inheritance). And holding assets in a separately titled account doesn’t affect the presumption that they are community property.
But in some cases there may be, as you suggest, advantages to a joint account. If spouses hold actual separate property in separately titled accounts, and then combine them in a joint account, and through the years community property, e.g., earnings, are added to that account, then all of the assets in the account may eventually be considered community property through the process of “commingling”.
I’m probably over my skis on this, so maybe one of our CPAs or tax lawyers will chime in. There’s also a very helpful discussion here: Our Greatest Hits | Community property step-up in basis – The CPA Journal
Thanks Andrew. That’s an interesting read at the link. The part I found a bit surprising was about possibly being able to carry the “community” nature of property from a community property state to a separate property state. That does sound like it might take some doing and wouldn’t necessarily be possible in all cases, but bears looking into if we ever change our residence.
It was surprisingly difficult to research this, so I’m also curious as to what pros may pipe in and say. Whatever else may be said, I’ll wonder about to what degree some things are generally accepted and would happen seamlessly, and what may be legal but be a struggle for heirs in practice. I know at least with our custodian, what I described should work the way I described.
Andrew, I agree with you. Here’s how my Baylor Law School professor Tom Featherston, an expert on Texas marital property and trust law, explained it: “If characterized as community property under Texas law, each spouse owns an equal undivided one-half interest in the property whether the property is titled in one spouse’s name or in both spouses’ names; if titled in one spouse’s name, the other spouse’s interest is equitable in nature.” This explanation is imbedded in a 40+ page CLE paper, with many other caveats: http://www.baylor.edu/law/facultystaff/doc.php/340198.pdf
Thanks for this link as well. I won’t get through it as quickly as Andrew’s 🙂
I wonder about the many other caveats. In our case, it’s just accounts, not real property, and we would be seeking to ensure they’re treated as community property, so I’m guessing the caveats won’t apply, but am still curious.
Michael, thanks for an interesting article It really highlights the significant differences in how the states tax us. There is value in simplifying our estates, but it may come at a tax cost as you explain. Your article also made me think how fortunate I am to be in a wonderful marriage with someone I trust completely. I can’t imagine how hard it must be if that were not the case.
Thanks Rick. Definitely something to be thankful for.
Michael, thanks for an explanation of this tax planning consideration. The nuances of our tax code can be interesting to read about—and frustrating to live with.
Thanks Edmund. I for one would gladly give up the interesting reading for a simpler tax code! As long as it is what it is though, I agree it’s worth spending time on it, as our tax burden is among those few things we can somewhat control.