By Ginsburg Law Group, P.C.

For married couples who own rental property in California, how the property is classified and held can have a significant impact on the taxes their families ultimately pay.

One of the most valuable tax benefits available to California married couples is the possibility of a double step-up in tax basis: one when the first spouse dies and another when the surviving spouse dies.

But does this benefit apply when rental property is held in a Qualified Terminable Interest Property (QTIP) trust? What happens if the deed lists the spouses as joint tenants? And what if the property was purchased with separate funds?

Understanding these distinctions can help families preserve substantial wealth.

What Is a Step-Up in Basis?

The tax basis of real estate generally begins with its purchase price, adjusted for improvements, depreciation, and other applicable tax items.

When real estate is sold, the difference between the amount realized and its adjusted tax basis generally determines the taxable gain or loss.

Under Internal Revenue Code § 1014, qualifying property acquired from a decedent generally receives a new basis equal to its fair market value at death, subject to applicable exceptions and valuation rules.

This is commonly called a step-up in basis, although the adjustment may also reduce basis when property values have declined. (For a general overview, see How to Get a Step-Up in Basis.)

Example: A California Rental Property

Assume a married couple owns a California rental property with:

• Original adjusted tax basis: $300,000
• Fair market value at the first spouse’s death: $900,000
• Fair market value at the second spouse’s death: $1,200,000

If the property qualifies for a full basis adjustment at each death, the surviving spouse’s combined basis generally becomes $900,000 after the first death.

When the surviving spouse later dies, the heirs may receive the property with a new basis of $1,200,000.

If the heirs sell shortly afterward for $1,200,000, they may owe little or no federal capital gains tax on the sale, assuming no intervening basis changes and disregarding selling expenses.

Without these adjustments, the taxable gain could be substantially higher.

Why California Community Property Rules Matter

California is a community property state.

Under California Family Code § 760, property acquired by a married person during marriage while domiciled in California is generally presumed to be community property unless an exception applies.

Community property commonly includes assets purchased using earnings accumulated during the marriage.

This classification can provide a significant federal income-tax advantage.

The 100% Step-Up at the First Spouse’s Death

Under IRC § 1014(b)(6), qualifying community property generally receives a basis adjustment on both spouses’ interests when the first spouse dies, provided at least half of the whole community interest is included in the deceased spouse’s gross estate.

This means the surviving spouse may receive a basis adjustment on the entire property, rather than only the deceased spouse’s half.

For example, if a community-property rental has an adjusted basis of $300,000 and is worth $900,000 at the first spouse’s death:

• The deceased spouse’s half generally adjusts to $450,000.
• The surviving spouse’s half generally adjusts to $450,000.
• The combined basis becomes $900,000.

This can be substantially more favorable than the treatment of property held in ordinary joint tenancy that does not qualify as community property. We cover the first-death rule in more depth in The California Estate-Planning Tax Break Many Couples Miss.

Does Joint Tenancy Mean the Property Is Not Community Property?

Not necessarily.

California courts recognize that joint tenancy title does not always defeat the community-property presumption.

In In re Marriage of Brace, 9 Cal. 5th 903 (2020), a divorce case, the California Supreme Court addressed the relationship between joint tenancy title and community-property classification.

Depending on the circumstances and applicable law, property acquired during marriage using community funds may remain community property despite joint tenancy title.

Under California Family Code § 852, a transmutation (a change in the character of property between spouses) is generally not valid unless it is made in writing by an express declaration that is made, joined in, consented to, or accepted by the spouse whose interest is adversely affected.

However, the applicable statutory rules, acquisition date, deed language, and evidence of the spouses’ intentions must be examined.

A deed describing spouses as joint tenants does not necessarily establish that the property is separate property for all purposes. (If you are moving property into a living trust, see Putting Your California Home Into a Living Trust Without Losing Community Property Status.)

When Might California Rental Property Be Separate Property?

Not every rental property owned by a married couple is community property.

Common exceptions (see California Family Code § 770) include:

• Property acquired before marriage. Real estate owned by one spouse before marriage generally remains separate property unless its classification is validly changed.
• Inherited property. Property inherited by one spouse generally constitutes separate property.
• Gifts to one spouse. Assets gifted exclusively to one spouse generally remain separate property.
• Property purchased with separate funds. Real estate purchased using traceable separate-property assets may retain separate-property character.
• Valid marital agreements. Prenuptial, postnuptial, or transmutation agreements may establish separate-property ownership.
• Property acquired while domiciled outside California. The property’s location alone does not establish community-property status. The spouses’ domicile, applicable law, and potentially quasi-community-property rules must be evaluated.

A property may also have mixed community and separate interests.

For this reason, the original acquisition documents and source of purchase funds are often as important as the current deed.

Can a QTIP Trust Preserve the Double Step-Up?

Yes. A properly structured QTIP trust can preserve the opportunity for a second basis adjustment at the surviving spouse’s death.

A Qualified Terminable Interest Property trust is commonly used when someone wants to provide for a surviving spouse while controlling who ultimately receives the remaining assets. (New to QTIP trusts? Start with What Is a QTIP Trust?)

For example, a spouse may want rental income to benefit the surviving spouse during life, with the property eventually passing to children.

Under IRC § 2056(b)(7), a QTIP trust generally requires the surviving spouse to be entitled to all trust income at least annually, with restrictions on appointing the property to anyone else during the surviving spouse’s lifetime.

A valid QTIP election is also required.

First Death: Community Property Basis Adjustment

If the rental property qualifies as community property, the entire property may receive a basis adjustment under IRC § 1014(b)(6) when the first spouse dies.

The deceased spouse’s interest may then pass into the QTIP trust according to the estate plan.

Second Death: QTIP Estate Inclusion

Under IRC § 2044, property subject to a valid QTIP election is generally included in the surviving spouse’s gross estate.

IRC § 1014(b)(10) generally provides a basis adjustment for qualifying property included under § 2044.

As a result, QTIP property can receive another basis adjustment at the surviving spouse’s death, even though the surviving spouse did not own that property outright.

If the surviving spouse also owns the other half of the rental property individually or through a revocable trust, that interest may independently qualify for a basis adjustment.

Together, these adjustments may produce a second full basis adjustment for the property.

Simply calling a trust a QTIP trust is not enough. The trust must meet the statutory requirements, and the appropriate QTIP election must be made.

QTIP Trust vs. Bypass Trust

Not all trusts provide the same tax treatment.

A traditional credit shelter trust, also called a bypass trust, is commonly structured to keep assets outside the surviving spouse’s taxable estate.

That exclusion may provide estate-tax benefits, but it can also prevent a second basis adjustment at the surviving spouse’s death.

A properly elected QTIP trust, by contrast, generally results in estate inclusion under IRC § 2044, permitting the corresponding basis adjustment under § 1014.

The choice depends on the couple’s financial circumstances, intended beneficiaries, estate-tax exposure, and other planning objectives.

A bypass trust may still be appropriate when estate-tax savings or asset protection outweigh the value of a future basis adjustment.

Rental Property Depreciation Creates Additional Tax Considerations

Rental property is different from a personal residence because owners generally claim depreciation deductions during ownership.

Depreciation reduces adjusted tax basis and may increase taxable gain upon sale.

When qualifying rental property receives a basis adjustment at death, the new basis generally reflects fair market value rather than the decedent’s historical depreciated basis.

This can substantially reduce potential capital gains and depreciation-related tax exposure.

The adjusted depreciable basis generally must be allocated between land and improvements.

Residential rental buildings are ordinarily depreciated over 27.5 years under federal tax rules.

However, the depreciation treatment of inherited interests and surviving-spouse interests can differ depending on ownership and tax circumstances. For QTIP property in particular, § 1014(b)(10) incorporates a rule from § 1014(b)(9) that can reduce the new basis by depreciation deductions the recipient was allowed on the property before the surviving spouse’s death, so how the trust allocates depreciation during administration should be reviewed with a tax advisor.

Does the Step-Up Affect California Property Taxes?

Federal income-tax basis adjustments and California property-tax reassessment rules are separate.

A step-up in federal income-tax basis does not automatically mean that a property will be reassessed for California property-tax purposes.

California’s Proposition 13 and Proposition 19 rules govern reassessment and applicable exclusions.

Transfers between spouses and certain trust transfers may qualify for exclusions.

However, transfers of rental property to children generally do not qualify for Proposition 19’s parent-child exclusion, which is limited to a family home or family farm.

Consequently, a property may receive a favorable federal income-tax basis adjustment while also becoming subject to California property-tax reassessment.

This distinction should be considered before transferring rental property into or out of a trust.

Five Questions Every California Rental Property Owner Should Ask

Before assuming a property qualifies for a double step-up, married couples should review:

• When was the property purchased? Before or during marriage?
• Where were the spouses domiciled? Were they California residents when the property was acquired?
• Where did the purchase funds come from? Community earnings, inheritance, separate assets, or mixed sources?
• How is the property titled? Community property, joint tenancy, separate property, LLC ownership, or trust ownership?
• What does the estate plan provide? Will the property pass outright, into a QTIP trust, or into a bypass trust?

The answers may determine whether the property qualifies for one or two full basis adjustments. (Own property in Arizona too? See Arizona Estate Planning: Can Married Couples Receive a Step-Up in Basis Twice?)

The Bottom Line

California’s community-property rules can provide married couples with a valuable federal income-tax advantage when they own appreciated rental real estate.

Qualifying community property may receive a full basis adjustment when the first spouse dies.

If the property is properly structured, a second adjustment may be available when the surviving spouse dies.

A QTIP trust can preserve that opportunity while allowing the first spouse to control who ultimately inherits the property.

However, the outcome depends on the property’s legal classification, trust provisions, estate-tax elections, and the circumstances at each death.

For families with valuable rental properties, careful estate planning can make a substantial difference in the taxes ultimately paid by future generations.

Contact Ginsburg Law Group

Ginsburg Law Group, P.C. assists individuals and families with estate planning, trusts, and related legal matters.

If you own California rental property and want to understand how community-property rules, QTIP trusts, or other estate-planning structures may affect your family’s inheritance, our attorneys can help you evaluate your options.

Schedule a consultation or email estates@ginsburglawgroup.com.

Legal References

• IRC § 1014: Basis of Property Acquired From a Decedent, including § 1014(b)(6) (Community Property) and § 1014(b)(10) (QTIP Property)
• IRC § 2044: Estate Inclusion of QTIP Property
• IRC § 2056(b)(7): Qualified Terminable Interest Property
• California Family Code § 760, § 770, § 852
• In re Marriage of Brace, 9 Cal. 5th 903 (2020)
• IRS Publication 551: Basis of Assets
• California Proposition 19 (State Board of Equalization)

Disclaimer: This article is provided for general educational purposes and does not constitute individualized legal or tax advice. Property classification, trust treatment, basis adjustments, and tax consequences depend on individual circumstances. Reading this article does not establish an attorney-client relationship.