What Is IRS Section 1014 for Inherited Property?

When an individual acquires an asset, its “cost basis” is the price paid to purchase it. This figure is used to calculate the taxable gain or loss upon the asset’s sale. The difference between the sale price and the basis determines the amount subject to capital gains tax. However, this method changes when property is inherited. The tax code has specific rules for inherited assets that can alter the financial outcome for the beneficiary.

The Basis Adjustment Rule for Inherited Property

The principle governing the basis of inherited property is found in Internal Revenue Code (IRC) Section 1014. This rule states that an heir’s basis in a property is adjusted to the Fair Market Value (FMV) of that asset on the date of the original owner’s death. This adjustment, often called a “step-up” or “step-down” in basis, erases the unrealized capital gain or loss that accumulated during the decedent’s lifetime. The new basis is determined by a qualified appraisal of the asset’s value at the time of death.

To illustrate a “step-up,” consider an individual who bought stock for $10,000. If that stock is worth $150,000 when the individual dies, the heir who inherits it receives a new basis of $150,000, and the $140,000 of appreciation is not subject to capital gains tax. Conversely, the rule can also result in a “step-down.” If the same stock was purchased for $150,000 but was only worth $10,000 at death, the heir’s basis would be reduced to $10,000, and the unrealized loss would vanish.

Executors of an estate have an alternative option under IRC Section 2032, known as the Alternate Valuation Date (AVD). This allows the executor to value the estate’s assets six months after the date of death. This election is only permissible if it results in a decrease in both the value of the gross estate and the amount of federal estate tax owed. If an asset is sold or distributed during that six-month window, its value is fixed on the date of that transaction, and the AVD election is irrevocable.

The basis determined through this process must be consistent with the value reported on the federal estate tax return, Form 706. Under IRC Section 6035, the executor is required to provide a statement, Form 8971, to both the IRS and the beneficiaries, identifying the value of each inherited property. This ensures that heirs cannot claim a higher basis than what was reported for estate tax purposes, with accuracy-related penalties under IRC Section 6662 for non-compliance.

Assets Covered by the Rule

The basis adjustment rule applies to most property transferred from a decedent to an heir, including many capital assets common to an estate. Examples of eligible assets include:

• Real estate, such as a primary residence, vacation homes, or rental properties
• Financial instruments like individual stocks, bonds, and mutual funds
• Tangible personal property, which can encompass items like vehicles, artwork, and jewelry
• Business interests
• Foreign-located property, as long as the beneficiary is a U.S. taxpayer

Exceptions and Special Property Rules

Certain assets and situations are excluded from the basis adjustment provisions. A primary category of excluded assets is “Income in Respect of a Decedent” (IRD), governed by IRC Section 691. IRD refers to income that the decedent was entitled to receive but had not yet collected before death. These assets do not receive a new basis; instead, the beneficiary who receives the income pays tax on it in the same way the decedent would have.

Common examples of IRD include:

• Distributions from traditional Individual Retirement Accounts (IRAs) and 401(k) plans
• Unpaid salaries or bonuses
• Accrued but unpaid interest and dividends

For instance, if a beneficiary inherits a traditional IRA, they will owe income tax on the distributions they take, just as the original owner would have.

Another exception applies to property gifted to the decedent shortly before their death. If an individual gifts an appreciated asset to someone who dies within one year of receiving the gift, and that same asset is then inherited back by the original donor, the basis adjustment does not apply. In this scenario, the donor retains their original basis in the property.

A special provision exists for married couples in community property states. When one spouse dies, both the decedent’s half and the surviving spouse’s half of the community property receive a full step-up in basis to the fair market value at the time of death. This “double step-up” is a distinct advantage, as in common law states, only the decedent’s share of jointly owned property receives the basis adjustment.

Tax Implications When Selling Inherited Assets

When an heir sells an inherited asset, the tax consequences are tied to the adjusted basis. For example, if an heir inherits stock with a stepped-up basis of $150,000 and sells it for $160,000, they will have a taxable capital gain of $10,000. If they sell it for $140,000, they will have a capital loss of $10,000.

A unique rule applies to the holding period of inherited assets. Regardless of how long the decedent or the heir actually owned the property, any gain or loss from its sale is automatically treated as long-term. This is beneficial for heirs because long-term capital gains are taxed at lower rates than short-term gains.

The sale of an inherited capital asset is reported to the IRS on Form 8949, Sales and Other Dispositions of Capital Assets. The heir enters “Inherited” as the acquisition date to signify the long-term holding period rule. Totals from Form 8949 are carried over to Schedule D (Form 1040), Capital Gains and Losses, to calculate the final tax liability.