Step-Up in Basis

Your cost basis is what you paid for an asset, adjusted over time, and it sets the taxable gain when you sell. Under Section 1014 of the tax code, property you inherit takes a new basis equal to its fair market value on the date the owner died. The owner’s lifetime appreciation is never taxed as income: not to the owner, who never sold, and not to you. You owe capital gains tax, and possibly the net investment income tax, only on growth after the death.

Three details matter. A sale of inherited property counts as long-term however soon after the death it happens. The executor may elect an alternate valuation date six months after death, but only if that lowers both the gross estate and the estate tax, and the heir’s basis then uses that date’s value. And the step-up doesn’t depend on owing estate tax or on filing an estate tax return.

The rule cuts both ways. If an asset is worth less than the owner paid, its basis steps down to the lower value, and the owner’s unrealized loss is gone for good.

The step-up covers property acquired from a decedent: assets left by will or inheritance, assets in a revocable living trust, and other property included in the owner’s taxable estate, such as jointly held property. Stocks, funds, real estate and business interests owned directly or in a taxable account all qualify.

The big exception is income in respect of a decedent, meaning income the owner had earned or deferred but not yet paid tax on. Traditional IRAs, 401(k)s and other pre-tax accounts get no step-up, so an heir pays ordinary income tax on withdrawals from an inherited IRA, which most non-spouse heirs must empty under the 10-year rule. Unpaid wages are treated the same way. An inherited Roth needs no step-up, because qualified withdrawals are already tax-free.

Lifetime gifts don’t qualify either: the recipient of an appreciated gift generally takes over the giver’s basis, and the built-in gain moves with it. Two anti-abuse rules close obvious workarounds. Appreciated property given to someone who dies within a year keeps its old basis if it passes back to the giver or the giver’s spouse. And a 2023 IRS ruling held that assets in an irrevocable grantor trust left out of the owner’s estate get no step-up.

For couples, what steps up at the first death depends on titling and state law. In the nine community property states, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin, both halves of community property generally get a new basis when either spouse dies, as long as at least half of its value is included in the deceased spouse’s estate. This is often called a double step-up.

Elsewhere, property a married couple holds as joint tenants with right of survivorship, or as tenants by the entirety, is generally treated as half owned by each spouse. Only the half included in the deceased spouse’s estate steps up; the survivor keeps the original basis in their own half.

The difference can be large. Take assets bought for $80,000 and worth $100,000 at the first death. In a community property state the survivor’s basis becomes $100,000. With joint tenancy elsewhere it becomes $90,000: $50,000 for the inherited half plus the survivor’s original $40,000. Either way, whatever the survivor still owns at their own death can step up again for the next heirs.

Because the step-up erases gains that were never taxed, it shifts several decisions. It favors holding highly appreciated assets until death over selling them, and it makes a taxable brokerage account or rental property an efficient thing to leave to heirs, while pre-tax retirement money is the least efficient.

That is part of the case for spending or converting pre-tax balances during retirement and letting appreciated taxable holdings pass at death, a pattern a tax-efficient withdrawal strategy can build in. It also lowers the value of tax-gain harvesting for assets you expect to hold for life, and raises the value of harvesting losses while you are alive, because a loss still in the portfolio at death disappears.

For rental real estate, the heir’s basis starts over at market value, so the heir can begin depreciating the building again from that value. Still, the step-up is one planning factor, not a reason on its own to keep an investment you would otherwise sell.

Most step-up errors surface years later, when an heir sells and has to prove a value nobody recorded, or when a family learns that an account it expected to reset did not. An heir who sells a decade after the death still needs the date-of-death value, and an appraisal is far easier to order at the time than to reconstruct. These are the mistakes that come up most often for heirs and executors.