IRS Step-Up in Basis at Death of Spouse: How It Affects Property Value

When a spouse passes away, their assets may receive a step-up in basis, which can significantly impact the surviving spouse’s tax obligations when selling inherited property. This adjustment resets the property’s value to its fair market price at the time of death, potentially reducing capital gains taxes if the asset is later sold.

Eligibility for Step-Up in Basis

Not all assets receive a step-up in basis upon a spouse’s death. Eligibility depends on ownership structure, state laws, and whether the property was considered community or separate property.

In community property states such as California and Texas, both halves of a jointly owned asset receive a full step-up in basis, meaning the surviving spouse’s portion is also adjusted to fair market value at the time of death. In contrast, common law states only allow a step-up for the deceased spouse’s share, leaving the surviving spouse’s portion unchanged.

Ownership structure also plays a role. Property held as joint tenants with right of survivorship (JTWROS) or tenants by the entirety qualifies for a step-up, but only for the deceased spouse’s share. Assets solely in the deceased spouse’s name or in a revocable living trust typically receive a full step-up. However, property in an irrevocable trust may not qualify, as it is no longer considered part of the deceased’s estate for tax purposes.

Property Type Distinctions

The step-up in basis applies differently depending on the type of asset inherited.

Real estate, such as a primary residence or rental property, often benefits the most. If a home was originally purchased for $200,000 but is worth $500,000 at the time of a spouse’s death, the new basis becomes $500,000. If the surviving spouse later sells the home for $525,000, only $25,000 is subject to capital gains tax instead of $325,000 under the original basis.

Investment assets, including stocks, bonds, and mutual funds, also receive a step-up. Any unrealized capital gains accumulated before the spouse’s death are erased. If shares of a stock were purchased for $50 each but are valued at $100 at the time of death, the new cost basis becomes $100 per share. If sold later at $110, only the $10 per share increase is taxable.

Personal property, such as artwork, collectibles, or jewelry, follows the same principle. Because these items do not have standardized market valuations, determining fair market value often requires professional appraisals. If an inherited painting was appraised at $50,000 at the time of death but was originally purchased for $5,000, the new basis is $50,000, reducing taxable gains if sold.

Calculating the Adjusted Basis

Determining the adjusted basis of inherited property requires an accurate valuation at the time of the original owner’s passing. The IRS allows fair market value to be established using either the date of death or an alternate valuation date, six months later. The alternate valuation method is only available if it reduces both the overall estate value and tax liability.

For assets without readily available market prices, such as privately held businesses or unique real estate holdings, a professional appraisal is often required. Valuation considers factors such as recent comparable sales, projected future earnings, and asset depreciation. If a family business is inherited, the step-up can apply to tangible assets like equipment and real estate, but intangible assets such as goodwill or trademarks may require separate valuation methods. The IRS scrutinizes these valuations, and discrepancies can lead to audits.

Inherited assets that generate income, such as rental properties or dividend-paying stocks, may require additional adjustments. Depreciation recapture rules apply when selling depreciable property, meaning any deductions previously claimed on the asset must be added back to taxable income. If a rental home had $50,000 in accumulated depreciation before the owner’s death, the new basis resets to fair market value, but future depreciation deductions start over based on this new figure.

Documenting the New Basis

Maintaining organized records is necessary to substantiate the stepped-up basis of inherited assets. The IRS requires documentation to support the valuation, especially if questioned during an audit. Official appraisals, brokerage statements, real estate assessments, and probate filings serve as primary evidence. For publicly traded securities, historical market data from the date of death can be retrieved from financial institutions or stock exchanges. Private investments, such as shares in a closely held corporation, may require financial statements or business valuation reports.

Real estate holdings require additional diligence. County property tax assessments alone are insufficient, as they may not reflect true market value. A professional appraisal or comparable sales data from the time of inheritance strengthens the basis claim. If the property was part of an estate subject to probate, court filings often include valuation details that can serve as supporting evidence. Retaining closing statements, mortgage documents, and records of property improvements ensures accurate adjustments when calculating future taxable gains.

Capital Gains Considerations

Selling an inherited asset after receiving a step-up in basis can significantly alter capital gains tax liability. The IRS treats inherited property as having a long-term holding period, regardless of how long the surviving spouse retains it before selling. This classification ensures that any taxable gain is subject to the more favorable long-term capital gains tax rates, which range from 0% to 20%, rather than the higher short-term rates that align with ordinary income tax brackets.

If the property continues to appreciate after the step-up in basis is applied, only the gain beyond the new valuation is taxable. For example, if a stock portfolio was stepped up to $500,000 at the time of death and later sold for $550,000, only the $50,000 increase is subject to capital gains tax. Without the step-up, the taxable gain could have been significantly higher. This distinction is particularly relevant for high-value assets such as real estate, where appreciation can be substantial over time.