Spouse Died With a Rental Property in California?

What Happens to Basis and Depreciation?

By Lawrence Do, EA | Former IRS Revenue Agent

When a spouse dies, rental property depreciation probably isn’t the first thing on anyone’s mind. Unfortunately, it’s also an area that can easily be overlooked when the next tax return is prepared.

This is particularly important in California because California is a community property state. Depending on how a rental property was owned, the death of a spouse can significantly change the property’s tax basis—and potentially increase the depreciation deduction available to the surviving spouse.

I’ve seen situations where the prior year’s depreciation schedule was simply carried forward after a spouse’s death. That may seem reasonable, but it can result in years of depreciation being calculated using an outdated basis.

What Happens to the Basis When a Spouse Dies?

For property acquired from a decedent, federal tax law generally provides for a basis determined using the property’s fair market value at the date of death, although exceptions apply.

For married couples, one of the most important questions is how the property was owned.

California is a community property state. If a rental qualifies as community property and the applicable federal requirements are satisfied, the basis adjustment generally applies to the entire community property—not simply the deceased spouse’s one-half interest.

That can make a substantial difference when a property has appreciated over many years.

However, you shouldn’t assume that every property with both spouses’ names on the deed receives the same treatment. Community property, separate property and other forms of joint ownership can produce different tax results.

What Happens to Rental Depreciation?

Residential rental buildings are generally depreciated under MACRS over 27.5 years. Land isn’t depreciable.

When the basis of a rental property changes following a spouse’s death, the depreciation calculation may also need to change.

This is where an easily missed problem can occur.

Tax software often carries depreciation schedules from one year to the next. If nobody considers the effect of the spouse’s death, the old depreciation can simply continue appearing on subsequent returns.

The numbers may look perfectly normal even though the underlying basis is no longer correct.

The proper treatment depends on how the property was owned, what interest was acquired and what assets are already included on the depreciation schedule. That’s why the old schedule should be reviewed rather than simply replaced with a new number.

A Real Client Situation

I recently reviewed the returns of a California taxpayer whose spouse had died while the couple owned rental properties.

The properties had been owned for years and had appreciated substantially.

After the spouse’s death, the taxpayer’s returns continued depreciating the properties using the historical depreciation schedules. The potential basis adjustment resulting from the spouse’s death had not been incorporated into the depreciation calculation.

At first glance, nothing on the returns necessarily looked unusual. The depreciation simply carried forward from the previous year.

But once we reviewed the underlying tax history, there was a significant issue.

We went back and examined the ownership of the properties, prior depreciation schedules, the date of the spouse’s death, historical property information and available evidence supporting fair market value around the date of death.

We also had to determine an appropriate allocation between land and the depreciable improvements.

After recalculating the depreciation using the adjusted basis, the taxpayer was entitled to substantially more depreciation than had originally been claimed.

In this case, correcting the depreciation resulted in several thousand dollars of estimated combined federal and California tax benefit.

Just as importantly, establishing the correct basis created an accurate depreciation schedule going forward and could affect the calculation of gain or loss if the properties are eventually sold.

This is a good example of why simply carrying forward an old depreciation schedule can cause a meaningful tax issue.

Client-identifying information and certain figures have been omitted or modified to preserve confidentiality. Results depend on each taxpayer’s individual facts and circumstances.

Don’t Forget the Land

A basis adjustment doesn’t mean the entire fair market value of the property becomes depreciable.

Land isn’t depreciable.

For example, suppose a rental property has a supported date-of-death fair market value of $900,000. If an appropriate allocation determines that $225,000 represents land and $675,000 represents the building, depreciation attributable to the building would generally be based on the applicable $675,000 building amount rather than the entire $900,000.

The land-versus-building allocation can therefore have a significant effect on the depreciation deduction.

How Do You Determine Date-of-Death Value?

Ideally, the taxpayer has a qualified appraisal or other reliable valuation evidence from around the date of death.

In reality, many surviving spouses don’t obtain an appraisal because they don’t realize the property’s value will later matter for income-tax purposes.

When a contemporaneous appraisal isn’t available, historical records and other valuation evidence may need to be reviewed to establish a reasonable and supportable fair market value.

Online property estimates can provide information, but they shouldn’t automatically be treated as equivalent to a qualified appraisal.

The larger the potential tax consequences, the more important supporting documentation becomes.

What If Your Tax Preparer Missed the Basis Adjustment?

If returns filed after a spouse’s death continued using an incorrect depreciation basis, it’s worth reviewing the issue rather than simply continuing the same schedule.

First determine:

• what the property’s correct basis should have been;

• when the incorrect depreciation began;

• how much depreciation was actually claimed;

• how much should have been claimed; and

• which tax years are affected.

Only then should you determine how the error should be corrected.

An amended return may be appropriate in some situations. In others, depreciation errors can involve accounting-method rules and require a different correction procedure.

In other words, discovering incorrect depreciation doesn’t automatically mean that filing an amended return is the correct solution.

Why Getting the Basis Right Matters Beyond This Year’s Refund

It’s easy to focus on the immediate depreciation deduction, but basis affects more than one tax return.

An incorrect basis can continue producing incorrect depreciation year after year. It can also affect the calculation of gain or loss when the rental property is eventually sold.

That’s why a surviving spouse should retain prior tax returns, depreciation schedules, deeds and ownership records, records of capital improvements, and documentation supporting the property’s fair market value around the date of death.

Fixing the issue now can prevent a much more difficult reconstruction years later.

The Bottom Line

The death of a spouse can materially change the tax basis and depreciation of California rental property.

For qualifying community property, the effect can be particularly significant because federal tax law may provide a basis adjustment for the entire community property rather than only the deceased spouse’s one-half interest.

But the correct treatment depends on the property’s ownership, community-property status, date-of-death value, land allocation and existing depreciation history.

If your spouse passed away while you owned California rental property—or if subsequent tax returns simply continued using the property’s old depreciation schedule—it may be worth having the basis and depreciation reviewed.

About the Author

Lawrence Do, EA is an Enrolled Agent, former IRS Revenue Agent, and founder of Do Tax & Advisory Group, Inc. His experience includes tax examinations, complex individual and business tax issues, and IRS compliance matters.

Do Tax & Advisory Group provides tax preparation and advisory services for individuals, rental property owners and small businesses.

Need help reviewing the basis or depreciation of a rental property? Contact Do Tax & Advisory Group to discuss your situation.

This article is intended for general informational purposes and does not constitute individualized tax, legal, or valuation advice. Tax treatment depends on the specific facts and circumstances.