The Double Basis Step-Up for Texas Community Property: What the IRS Wants to See

When someone dies, the property they owned generally takes a new income tax basis equal to its fair market value at death. That is IRC 1014. In most states, a surviving spouse gets that new basis only on the half of jointly held property that belonged to the person who died. The survivor's own half keeps its old, often tiny, basis.

Texas community property works differently, and much better. Under IRC 1014(b)(6), the surviving spouse's half of community property is also treated as acquired from the decedent, as long as at least half of the community interest was included in the decedent's gross estate. Both halves get a new basis. Tax people call it the double step-up.

For a Texas widow selling a house bought in 1985 or a brokerage account built over forty years, that rule can wipe out most of the taxable gain. But it is a rule the survivor has to prove, usually years later, to an IRS that sees only the sale.

Why this turns into an IRS problem

Brokerages issue Form 1099-B showing proceeds, and for older or transferred positions they often show no basis or the original purchase price. Title companies issue Form 1099-S showing the gross sale price of real estate. Neither form knows anything about community property or a death.

If the survivor's return does not report the stepped-up basis correctly on Form 8949 and Schedule D, the IRS's matching program sees a large sale with little or no basis and proposes tax on the full amount. If the return claims a stepped-up basis without support, an examiner may ask for proof. Either way, the burden of proving basis is on the taxpayer.

Element one: it has to be community property

The full step-up applies only to community property. Separate property belonging to the surviving spouse, such as property the survivor owned before marriage or inherited, does not get a new basis because the other spouse died. And the decedent's separate property gets a new basis under the general rule, but there is no surviving spouse's half to adjust.

Texas presumes that property possessed by either spouse during or at the dissolution of marriage is community property. That presumption helps most survivors. But mixed histories complicate things: a house one spouse owned before marriage with a mortgage paid down by community wages, a brokerage account that started with an inheritance and grew with community contributions, a family business.

When character is unclear, the survivor needs the documents that tell the story: deeds, closing statements, account opening records, marital agreements, and any partition agreements. Questions about how Texas law characterizes a particular asset should go to a Texas attorney who practices in that area, ideally the one handling the estate.

Element two: the value at death

The new basis is generally the fair market value on the date of death, or on the alternate valuation date if the estate properly elected it under IRC 2032. For publicly traded securities, value is easy to document from brokerage records for the date of death. For real estate, closely held businesses, mineral interests, and ranch land, value requires an appraisal.

An appraisal obtained near the date of death is far more persuasive than one prepared retroactively after an IRS notice arrives. Retroactive appraisals are allowed and sometimes necessary. They just invite more questions. If a spouse has died recently, get the appraisals now, even if nobody plans to sell.

When an estate tax return is required, IRC 6035 may require the executor to furnish basis information to the IRS and to beneficiaries on Form 8971, and IRC 1014(f) can require the beneficiary's basis to be consistent with the value finally determined for estate tax purposes. Most estates are not large enough to require a Form 706, so most survivors rely on appraisals and records rather than estate tax filings.

Depreciation and other adjustments

If the community property was a rental house or business asset, the new basis replaces the old depreciated basis. The survivor starts a new depreciation schedule based on the stepped-up value of the building. Many survivors keep using the old schedule because the preparer carried it forward. That understates depreciation every year, and it creates errors when the property is later sold.

If the property passes through the estate rather than directly to the survivor, the estate itself may sell it and report the sale on Form 1041. The basis rules are the same. The reporting is different. Make sure whoever sells reports the sale on the right return.

Answering a CP2000 or an exam on a basis issue

When the IRS proposes tax on a sale because basis was missing, the response is a package, not a sentence. It should show the date of death, the community property character of the asset, the fair market value at death and how it was determined, and the corrected computation of gain or loss.

Include the death certificate, the appraisal or brokerage valuation, deeds or account records showing community ownership, and a short cover letter citing IRC 1014(a) and 1014(b)(6). If the house was the survivor's residence, also address the IRC 121 exclusion. Section 121 can exclude up to $250,000 of gain for a single filer, and a surviving spouse who sells within two years after the date of death can generally still use the $500,000 limit if the requirements were met immediately before the death.

These cases are very fixable when the records exist. Most of the work is collecting them. The CP2000 process itself is covered in my Dallas audit representation guide.

Common mistakes I see

• Reporting a sale with the original purchase price as basis because nobody told the preparer about the death.
• Stepping up only half of community property, as if Texas were a common law state.
• Stepping up property that was actually the survivor's separate property.
• Continuing old depreciation schedules after the death instead of starting new ones.
• Waiting until an IRS notice to get an appraisal for real estate, minerals, or a business.
• Missing that inherited mineral interests have their own basis and depletion issues, covered in my guide to selling Texas mineral rights.

The double step-up is one of the best things Texas community property law does for families. It is also a rule that only works on paper if you have the paper. If an IRS notice is proposing tax on a sale after a spouse's death, or you are about to sell and want to get it right the first time, let's talk: 813-229-7100.