Capital Gains Tax When Selling Trust Property California: Complete Tax Guide

When a trust sells property during administration, understanding capital gains tax is essential. The good news: most trust property receives a "stepped-up basis" at death, significantly reducing or eliminating capital gains. The bad news: trustees who don't understand these rules can trigger unnecessary taxes or make costly reporting mistakes.

This guide explains everything trustees need to know about capital gains tax when selling trust property in California.

What Is Capital Gains Tax?

Capital gain = Sale price - Basis - Selling costs

Tax rates (2024):

• Short-term (held <1 year): Ordinary income rates (up to 37%)
• Long-term (held >1 year): 0%, 15%, or 20%
• Plus: 3.8% Net Investment Income Tax on undistributed gains
• California: Up to 13.3% additional state tax

The Stepped-Up Basis Rule

How It Works

General rule: Property inherited through a trust receives a new tax basis equal to its fair market value on the date of death.

Example:

• Settlor bought house in 1990 for $200,000
• Settlor dies in 2024, house worth $1,200,000
• New basis: $1,200,000 (not $200,000)
• If trust sells for $1,250,000:
  • Gain = $1,250,000 - $1,200,000 - selling costs
  • Gain = $50,000 (not $1,050,000!)

This saves tens or hundreds of thousands in taxes.

What Gets Step-Up

Assets that receive step-up:

• Real estate
• Stocks and bonds
• Business interests
• Collectibles and artwork
• Vehicles
• Jewelry

Assets that DON'T receive step-up:

• IRAs and retirement accounts
• Annuities
• Income in respect of decedent (IRD)

California Community Property

Special rule: If property was community property, BOTH halves get step-up at first spouse's death.

Example:

• Husband and wife own house as community property
• Bought for $300,000, now worth $900,000
• Husband dies
• Entire property (both halves) gets step-up to $900,000
• Wife's basis: $900,000 (not $750,000)

This is a huge California advantage - not available in common law states.

Calculating Capital Gains

Step 1: Determine Basis

Date-of-death value:

• Obtain professional appraisal
• Use as of date settlor died
• This becomes your basis

Alternate valuation date:

• Can elect to value 6 months after death
• Only if reduces estate tax
• Rarely used

Example basis calculation: Property appraised at $850,000 on date of death = Basis is $850,000

Step 2: Calculate Gain

Formula:

Sale Price
- Adjusted Basis (date-of-death value)
- Selling Costs (commissions, fees, closing costs)
= Taxable Gain

Example:

• Sale price: $900,000
• Basis: $850,000
• Realtor commission (6%): $54,000
• Escrow/closing costs: $3,000
• Taxable gain: $900,000 - $850,000 - $57,000 = -$7,000 (LOSS)
• No tax owed

Step 3: Apply Tax Rates

If gain is taxable:

Gain Type	Federal Rate	CA Rate	Total
Short-term	Up to 37%	Up to 13.3%	Up to 50.3%
Long-term	0-20%	Up to 13.3%	Up to 33.3%
Plus NIIT	3.8%	N/A	3.8%

Holding period: Inherited property is automatically long-term (even if sold immediately).

Special Situations

Real Estate Improvements

After death improvements:

• Capital improvements increase basis
• Repairs do not
• Keep receipts

Example:

• Basis at death: $500,000
• New roof (capital improvement): $25,000
• Paint (repair): $5,000
• Adjusted basis: $525,000 (roof adds, paint doesn't)

Depreciated Property

Rental or business property:

• Must recapture depreciation taken
• Reduces step-up benefit
• Recapture taxed at 25% (federal)

Property Sold Below Basis

Capital loss:

• Can offset other capital gains
• Up to $3,000 offset against ordinary income
• Excess carries forward

Example:

• Basis: $300,000
• Sale price: $250,000
• Loss: $50,000
• Use to offset other trust gains

Partial Interests

If trust owns percentage:

• Only that percentage gets step-up
• Co-owners' portions have their own basis

Appreciated After Death

Problem: Property appreciates between death and sale

Example:

• Death date value: $800,000
• Sale price 18 months later: $950,000
• Taxable gain: $150,000 (plus selling costs)

Solution: Distribute property to beneficiaries before sale if possible.

Reporting Requirements

Form 1099-S

Seller receives:

• Form 1099-S reporting gross proceeds
• Sent by escrow/title company
• IRS receives copy

Trust must report even if no gain.

Form 1041 Schedule D

Report capital gains on:

• Schedule D (Capital Gains and Losses)
• Attached to Form 1041

Information needed:

• Description of property
• Date acquired (date of death)
• Date sold
• Sale price
• Basis (date-of-death value)
• Selling expenses
• Gain or loss

Form 8949

Required before Schedule D:

• Sales and Dispositions of Capital Assets
• Lists each transaction
• Transfers totals to Schedule D

Distribution to Beneficiaries

If gain distributed:

• Reported on Schedule K-1
• Beneficiaries pay tax
• Usually better than trust paying (lower rates)

Tax Planning Strategies

1. Sell During Administration

Benefit: Property has stepped-up basis

• Minimal or no gain
• Best time to sell

Timing: Within 6-18 months of death typically optimal

2. Distribute Before Sale

Strategy:

• Distribute property to beneficiaries
• Beneficiaries sell
• Beneficiaries pay lower tax rates

Example:

• Trust faces 37% + 3.8% = 40.8% rate
• Beneficiary faces 15% rate
• Saves 25.8% on gain

Caution: Only works if beneficiaries cooperate.

3. Offset Gains with Losses

Tax loss harvesting:

• Sell losing investments
• Offset gains from property sale
• Losses carry forward

4. Time the Sale

Market timing:

• Don't rush if market is down
• Wait for better pricing
• Balance holding costs vs. market recovery

5. Installment Sale

If selling to beneficiary or third party:

• Spread gain over multiple years
• Report using installment method
• Defer tax

Requirements:

• At least one payment after tax year of sale
• Interest charged on installments

6. 1031 Exchange

Like-kind exchange:

• Defer capital gains
• Swap investment/business property
• Complex rules

Note: Personal residence doesn't qualify (but see §121 exclusion below).

7. Section 121 Exclusion

Primary residence exclusion:

• $250,000 per person excluded
• Must have lived in property 2 of last 5 years

For inherited property:

• Beneficiary can use if moves in and meets 2-year test
• Trust itself doesn't qualify
• Must distribute to beneficiary first

Common Mistakes

1. Using Original Purchase Price as Basis

Mistake: Trustee uses settlor's original cost as basis

Example:

• Original cost: $100,000
• Date-of-death value: $500,000
• Trustee incorrectly uses $100,000 basis
• Overpays tax on $400,000 phantom gain

Solution: Always use stepped-up basis.

2. No Appraisal

Mistake: No formal appraisal obtained

Problem:

• Can't prove basis
• IRS may challenge
• Lose deduction for selling costs if can't document

Solution: Get professional appraisal within 60-90 days of death.

3. Not Including Selling Costs

Deductible selling costs:

• Real estate commissions
• Title insurance
• Escrow fees
• Transfer taxes
• Legal fees for sale
• Recording fees

These reduce gain dollar-for-dollar.

4. Forgetting Improvements

After-death improvements increase basis:

• New roof
• HVAC system
• Additions
• Major renovations

Keep receipts and add to basis.

5. Distributing Property with Built-In Gain

Problem: Trustee distributes property that hasn't received step-up

Example:

• Trust bought property after death for $300,000
• Worth $400,000 at distribution
• Beneficiary's basis: $300,000 (carryover, not stepped-up)
• If sold immediately, $100,000 taxable gain

Solution: Sell before distribution if property was acquired after death.

California-Specific Issues

Proposition 19

Limits parent-child exclusion:

• Effective February 16, 2021
• Primary residence: $1M assessed value exclusion
• Other property: No exclusion (full reassessment)

Property tax impact:

• Property may be reassessed at current value
• Can trigger huge property tax increase
• Consider when deciding whether to keep or sell

California Capital Gains Rate

State tax up to 13.3%:

• Added to federal rate
• No preferential long-term rate
• All gains taxed as ordinary income

Total rates can exceed 37% (federal + state + NIIT).

Form 541

Report capital gains on:

• California Form 541 Schedule D
• Follows federal but different rates

When to Get Professional Help

Hire a CPA if:

• Property value over $500,000
• Multiple properties sold
• Complicated basis calculations
• Estate tax involved (Form 706)
• Business property with depreciation
• Installment sales
• 1031 exchange
• Trust faces significant tax liability

Tax preparation fees are deductible trust expenses.

Documentation Checklist

Keep these records:

• Date-of-death appraisal
• Escrow/closing statement
• Form 1099-S
• Receipts for capital improvements
• Title insurance policy
• Grant deed recorded
• Realtor commission statement
• Prior year tax returns
• Trust document
• Distribution records if property distributed

Retain for 7 years after tax return filed.

Example Scenarios

Scenario 1: Simple Sale - No Tax

Facts:

• House, stepped-up basis: $800,000
• Sale price: $825,000
• Realtor commission: $49,500
• Closing costs: $3,000

Calculation:

• Gain: $825,000 - $800,000 - $52,500 = -$27,500 LOSS
• Tax owed: $0

Scenario 2: Appreciated Property - Tax Due

Facts:

• Condo, stepped-up basis: $400,000
• Sale 2 years later: $550,000
• Selling costs: $35,000

Calculation:

• Gain: $550,000 - $400,000 - $35,000 = $115,000
• Federal tax (20%): $23,000
• NIIT (3.8%): $4,370
• CA tax (13.3%): $15,295
• Total tax: $42,665

Better strategy: Distribute to beneficiaries before sale (might save $20,000+).

Scenario 3: Rental Property

Facts:

• Rental, original cost: $250,000
• Depreciation taken by settlor: $50,000
• Adjusted basis at death: $200,000
• Stepped-up basis: $600,000
• Sale price: $650,000
• Selling costs: $40,000

Calculation:

• Basis: $600,000 (stepped-up)
• Gain: $650,000 - $600,000 - $40,000 = $10,000
• No depreciation recapture (wiped out by step-up)
• Tax on $10,000 gain only

Conclusion

Capital gains tax on trust property sales can be minimized or eliminated through proper planning:

Key takeaways:

• Use stepped-up basis (date-of-death value)
• Obtain professional appraisal
• Include all selling costs
• Time sales strategically
• Consider distributing before sale
• Keep detailed records
• Consult with tax professional

The stepped-up basis rule is one of the most valuable tax benefits in estate planning - but only if you use it correctly.

Related Articles

Learn more about trust property and tax issues:

• Form 1041 Trust Tax Return Guide California - Complete guide to filing trust income tax returns, reporting capital gains, distributable net income, and trustee tax obligations.

• Real Estate in Trust Administration California - Process for selling or transferring trust real estate, market value determination, and distribution to beneficiaries.

• Income vs. Principal Trust Administration - How to allocate capital gains between income and principal beneficiaries under California trust accounting rules.

• Trust Administration IRS Audit - What triggers audits of trust property sales, documentation needed, and how to respond to IRS inquiries.

• Common Trust Administration Mistakes California - Avoid costly errors including improper tax basis calculations and capital gains reporting mistakes.

Need Help With Trust Property Sales and Taxes?

If you're administering a trust and facing capital gains tax issues on property sales, our attorneys work with tax professionals to minimize your tax liability and ensure proper reporting.

Contact us for a consultation about your trust administration tax matters.

This article is for informational purposes only and does not constitute legal or tax advice. Capital gains tax rules are complex and fact-specific. Consult with qualified tax professionals about your specific situation.