A step-up in basis is a tax rule that adjusts the value of an inherited asset to its fair market value on the date of the original owner’s death, rather than the amount that owner originally paid for it. This adjustment can substantially reduce, or even eliminate, the capital gains tax a beneficiary would otherwise owe when they later sell the inherited asset. This rule is an important estate planning consideration when a family is deciding whether to sell an inherited home, business interest, or investment portfolio, since the tax consequences can vary widely depending on when the sale happens.
Why the Step-Up in Basis Rule Exists
When someone buys an asset, such as stock or real estate, their “basis” is generally what they paid for it. If they sell the asset for more than that basis, they owe capital gains tax on the difference. Without a step-up rule, an heir who inherited an asset would keep the original owner’s basis, potentially owing tax on decades of appreciation the heir never benefited from until the asset was inherited.
This concept applies whether the inherited asset was purchased decades ago or acquired more recently, since the original purchase price is no longer the relevant figure once the step-up applies.
Congress addressed this under 26 U.S.C. § 1014, which generally resets the basis of inherited property to its fair market value at the date of death. This means a beneficiary who sells the asset shortly after inheriting it may owe little or no capital gains tax, since the taxable gain is measured from the stepped-up basis rather than the original purchase price.
How the Step-Up in Basis Works
Here’s a simple example of how step-up in basis works for inherited stock: a parent buys stock for $50,000, and by the time they pass away, the stock is worth $300,000. Without a step-up in basis, an heir who later sold that stock for $310,000 would owe capital gains tax on $260,000 of appreciation. With the step-up rule, the heir’s basis becomes $300,000, the fair market value at death, so only $10,000 of the sale price would be taxable gain.
This same principle applies to real estate, business interests, and most other capital assets that are includable in the decedent’s estate. The step-up is generally automatic and does not require the beneficiary to file any special election. However, the fair market value at death still needs to be documented, often through an appraisal or other valuation. Keeping that documentation on hand matters, since a beneficiary may need to justify the stepped-up basis to the IRS years later if the asset is eventually sold. This is especially true for real estate and closely held business interests, where values can be harder to establish long after the fact than they are at the time of death.
Assets That Qualify for a Step-Up in Basis
Most inherited property qualifies for a step-up in basis when it passes through an estate. Common examples include:
- Publicly traded stocks and mutual funds held in the decedent’s name
- Real estate, including a primary residence, vacation property, or rental property
- Interests in a closely held business or partnership
- Personal property such as art, vehicles, or collectibles included in the estate
Assets That Do Not Get a Step-Up in Basis
Some assets are excluded from this rule because of their tax treatment. These generally include:
- Traditional IRAs, 401(k) accounts, and other tax-deferred retirement accounts
- Annuities that have not yet been fully paid out
- Assets already transferred out of the estate before death, such as certain lifetime gifts
- Property that constitutes a right to receive income the decedent had already earned, known as income in respect of a decedent
These assets typically carry over the decedent’s original basis or tax treatment, so a beneficiary can still owe tax on the full amount when they eventually withdraw or sell them.
Step-Up in Basis for Community Property in California
California’s community property rules add an important benefit for married couples. Under § 1014(b)(6), when one spouse passes away, community property receives a full step-up in basis on both the deceased spouse’s half and the surviving spouse’s half, not just the portion that belonged to the deceased spouse. This differs from separately owned property in common law states, where typically only the deceased owner’s share receives a step-up.
This distinction matters most for appreciated assets, such as a family home or investment portfolio held as community property for decades. A surviving spouse who later sells that home may owe little or no capital gains tax on the appreciation that accrued during the marriage, since the entire property, not just half of it, receives the adjusted basis. Confirming that an asset is properly classified and documented as community property, rather than separate property, can make a meaningful difference in the tax outcome for a surviving spouse.
How This Affects Estate Planning
Because the step-up in basis can eliminate so much built-in capital gains tax, it affects decisions about whether to hold appreciated assets until death or transfer them earlier through lifetime gifts, which do not receive the same adjustment. It also affects how trusts are structured, since some irrevocable trusts may not allow assets to receive a step-up at the grantor’s death, depending on how the trust is drafted. Factoring this rule into your estate plan from the start can help avoid surprises for your beneficiaries later.
These are the kinds of details that come up regularly during probate and trust administration, when beneficiaries need to establish the correct basis for assets they are about to sell or distribute.
Talk to a San Diego Estate Planning Attorney at Frisella Neilson, APC
Attorney Lisa J. Frisella and our San Diego firm work with clients to structure estates to take full advantage of the step-up rule where it applies, while flagging assets that fall outside it. Our team at Frisella Neilson, APC helps California families understand how tax rules like the step-up in basis affect their estate plan and their heirs.
Call 619-260-3500 or contact our firm to talk through your assets and how they may be treated after your lifetime.
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