What Is Section 1014 of the Internal Revenue Code?

Section 1014 of the Internal Revenue Code is a federal tax law that addresses the tax basis of property transferred from a deceased individual to an heir. This provision is a component of estate planning with implications for beneficiaries. The concept of “basis” is fundamental for calculating capital gains or losses when an inherited asset is sold. Basis is the amount you have invested in an asset for tax purposes.

Section 1014 establishes that the basis of property acquired from a decedent is its fair market value at the time of the owner’s death. This rule can reduce or even eliminate the capital gains tax owed when they sell the inherited property.

The Step-Up in Basis Explained

Cost basis is the original value of an asset for tax purposes, usually the purchase price. Section 1014 alters this calculation for inherited assets by adjusting the basis to its fair market value (FMV) on the date of the owner’s death. This adjustment is known as a “step-up” in basis.

For example, an individual may have purchased stock for $10,000 that was worth $100,000 on the day they died. The heir who inherits this stock receives a new basis of $100,000, and if they sell it immediately, there is no capital gain to report.

The same principle applies in reverse, resulting in a “step-down” in basis. If the same stock was purchased for $10,000 but was only worth $5,000 on the date of death, the heir’s basis would be stepped down to $5,000.

The Internal Revenue Service also grants the inheritor a long-term holding period for the asset, regardless of how long it was held. This allows any future gains to be taxed at more favorable long-term capital gains rates.

Determining the New Basis

The default valuation date for establishing the new basis of an inherited asset is the date of the decedent’s death. The fair market value on this day becomes the heir’s new cost basis. An executor of an estate has an alternative option for valuation under Section 2032 of the tax code. The executor can elect to use the Alternate Valuation Date (AVD), which values assets six months after the date of death.

This election is only permissible if it results in a decrease in both the gross value of the estate and the federal estate tax liability. Establishing the fair market value varies depending on the type of asset. For publicly traded securities, the FMV is determined by averaging the highest and lowest selling prices on the valuation date. For other assets, such as real estate or private business interests, a formal appraisal by a qualified professional is required.

Assets Covered by the Rule

The basis adjustment rule under Section 1014 applies to a wide range of capital assets included in a decedent’s gross estate for federal estate tax purposes. This connection to the gross estate is a guide for determining which assets are eligible. The rule is not limited to assets held within the United States; it can also apply to foreign property inherited by a U.S. taxpayer.

Common examples of assets that receive this tax treatment include real estate, such as a primary residence, vacation homes, or rental properties. Investment assets held in taxable brokerage accounts are also covered, including individual stocks, bonds, and shares in mutual funds.

Tangible personal property also qualifies for the basis adjustment, including items like artwork, antiques, and jewelry. The rule’s application extends to business interests, such as ownership in a closely held corporation or a partnership.

Exceptions and Special Considerations

A category of assets that does not receive a step-up in basis is known as “Income in Respect of a Decedent” (IRD). IRD refers to income that the decedent was entitled to but had not yet received at the time of death. Because this income was not yet recognized for tax purposes, it does not qualify for a basis adjustment. The beneficiary who receives these assets will pay income tax on them in the same way the decedent would have.

The most common examples of IRD assets are funds held in tax-deferred retirement accounts. This includes:

• Traditional Individual Retirement Arrangements (IRAs)
• 401(k)s
• 403(b)s
• Other qualified retirement plans

When a beneficiary takes a distribution from an inherited retirement account, the amount is taxable as ordinary income. Other examples of IRD include unpaid salary, bonuses, and installment payments from a sale that were not completed before death.

Another exception involves property that was 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 the asset then passes back to the original donor or the donor’s spouse, the step-up in basis is disallowed. This rule prevents individuals from exploiting the basis adjustment to erase capital gains on assets they intend to reacquire.

A special rule applies to married couples who live in community property states. In these states, most property acquired during the marriage is considered to be owned equally by both spouses. 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.