IRS Step-Up Basis Rules for Inherited Assets
Understand the tax treatment of inherited assets. A basis adjustment at the time of death can reduce the capital gains tax liability for beneficiaries upon sale.
The step-up in basis is a tax provision that adjusts the value of an inherited asset for tax purposes. When an individual inherits property, the Internal Revenue Service (IRS) permits the asset’s cost basis to be “stepped up” to its fair market value on the date of the original owner’s death. This revaluation is a component of estate planning because it directly impacts the amount of capital gains tax an heir might pay when they sell the asset. By resetting the basis, the tax code prevents the beneficiary from being taxed on the appreciation that occurred during the deceased owner’s lifetime, reducing the heir’s potential tax burden.
How Step-Up Basis Works
An asset’s cost basis is its original purchase price, plus any costs of acquisition and improvements. A capital gain is the profit realized from the sale of an asset, calculated as the selling price minus the cost basis. For example, a parent purchased stock for $10,000 that was worth $100,000 at the time of death.
When their child inherits the stock, the child’s cost basis is stepped up to $100,000. If the child immediately sells the stock for that amount, they would have no capital gain and owe no federal tax on the sale. The $90,000 increase in value that occurred during the parent’s ownership is not taxed to the heir.
This treatment contrasts with gifted assets. If the parent had gifted the stock, the child would receive a “carryover basis” of the original $10,000. A sale for $100,000 would then result in capital gains tax on the $90,000 profit.
If an asset’s value has decreased below its original purchase price at the time of death, the basis is “stepped down.” This could result in a larger capital gain or smaller capital loss for the heir upon sale.
Determining the New Basis
Establishing the new, stepped-up basis requires determining the asset’s Fair Market Value (FMV) on the date of the owner’s death. For real estate, a formal appraisal by a qualified professional is required. For publicly traded securities like stocks and bonds, the FMV is calculated by averaging the highest and lowest selling prices on the date of death. For other assets, such as valuable art or collectibles, an expert appraisal is necessary.
In some situations, the executor of the estate may elect to use the Alternate Valuation Date (AVD). This allows the assets to be valued six months after the date of death, as detailed in Internal Revenue Code Section 2032. This election is only permissible if it results in a decrease in both the total value of the gross estate and the federal estate tax owed. The decision to use the AVD must be applied to all assets within the estate.
Assets That Qualify for Step-Up Basis
The step-up in basis rule applies to a wide range of capital assets passed to beneficiaries after death. Common examples include real property, such as a family home or land, and financial instruments like stocks, bonds, and mutual funds. Tangible personal property, which can include valuable items like artwork and antiques, also qualifies for this provision.
Certain assets are specifically excluded from the step-up in basis provision, categorized as “Income in Respect of a Decedent” (IRD). This category includes tax-deferred retirement accounts such as traditional IRAs and 401(k)s, as well as pensions and annuities. Distributions from these accounts are taxed as ordinary income to the beneficiaries when they are received.
A notable exception exists for married couples in community property states. In these jurisdictions, when one spouse dies, both halves of the couple’s community property receive a full step-up in basis to the fair market value. This applies not only to the deceased spouse’s share but also to the surviving spouse’s share.
Reporting the Sale of Inherited Property
When a beneficiary sells an inherited asset, the transaction must be reported to the IRS on Form 8949, Sales and Other Dispositions of Capital Assets. This information is then summarized on Schedule D, which is filed with the taxpayer’s Form 1040.
On Form 8949, the beneficiary enters “Inherited” as the “Date Acquired.” For the “Cost or other basis,” the taxpayer enters the stepped-up basis, which is the Fair Market Value on the decedent’s date of death or Alternate Valuation Date.
The sale price is entered, and the gain or loss is calculated by subtracting the basis from the sale proceeds. Because inherited property is automatically considered held for more than one year, any resulting gain or loss is treated as long-term. Long-term capital gains are taxed at lower rates than short-term gains.