What Is Step-Up Basis and How Does It Work?

Step-up basis is a tax provision that adjusts the value of an inherited asset for tax purposes, resetting its value to the fair market value at the time of the original owner’s death. This adjustment can reduce the capital gains tax owed by a beneficiary when they sell the inherited property. Understanding this rule is part of managing the financial implications of an inheritance.

Understanding Step-Up Basis

To understand step-up basis, one must first know “cost basis,” which is the original purchase price of an asset. When an asset is sold, the difference between its sale price and its cost basis determines the capital gain or loss for tax purposes. A higher cost basis results in a lower taxable gain.

The step-up basis rule, found in Section 1014 of the Internal Revenue Code, adjusts the basis of an inherited asset to its fair market value on the date of the previous owner’s death. This means the appreciation in value that occurred during the original owner’s lifetime is not subject to capital gains tax for the heir. Any gain that accrued before the inheritance is erased for income tax purposes.

Consider a parent who purchased stock for $10,000. If the stock is worth $100,000 when the parent passes away, the child who inherits it receives a new, stepped-up basis of $100,000. If the child immediately sells the stock for $100,000, there is no capital gain to report. Without the step-up rule, the child would have inherited the original $10,000 basis, and a sale at $100,000 would have triggered a taxable capital gain of $90,000.

Assets Affected by the Step-Up Rule

The step-up basis rule applies to certain assets while specifically excluding others, leading to different tax outcomes for beneficiaries.

Assets That Qualify

A broad range of assets are eligible for a step-up in basis.

• Real estate, such as a primary residence, vacation home, or investment properties
• Taxable brokerage accounts holding stocks, bonds, mutual funds, and ETFs
• Tangible personal property like valuable art and collectibles
• Ownership stakes in private businesses and certain digital assets like cryptocurrencies

Assets That Do Not Qualify

Certain assets are excluded from the step-up basis rule, primarily those that have already benefited from tax deferral. This category includes retirement accounts like traditional IRAs, 401(k)s, and pensions, as well as annuities. These assets are classified as “Income in Respect of a Decedent” (IRD), meaning the income was earned by the decedent but not received before death. Withdrawals from these accounts are taxed as ordinary income to the beneficiary.

Exceptions and Alternative Scenarios

While the step-up in basis is a general rule for inherited assets, several exceptions and alternative treatments exist. These scenarios can alter the tax basis of an asset for an heir, sometimes in a less favorable way.

Step-Down Basis

The basis adjustment rule works in both directions. If an asset’s fair market value on the date of death is lower than the original owner’s cost basis, the heir receives a “step-down” in basis. For example, if an individual purchased stock for $50,000 and it was only worth $30,000 upon their death, the heir’s basis is stepped down to $30,000. The original $20,000 capital loss is lost and cannot be claimed by the heir. If the heir later sells the stock for $35,000, they would have a taxable gain of $5,000.

Gifts vs. Inheritance

The tax treatment of assets received as a gift during the owner’s lifetime is different from that of inherited assets. Gifted assets do not receive a step-up in basis. Instead, the recipient takes on the donor’s original cost basis, a concept known as “carryover basis.” If a parent gifts stock with a $10,000 basis that is now worth $100,000, the recipient’s basis is also $10,000. A subsequent sale for $100,000 would result in a $90,000 taxable capital gain for the recipient.

Community Property States

A special rule provides a benefit for married couples in community property states. In these states, assets acquired during the marriage are considered owned equally by both spouses. Upon the death of one spouse, not only does the deceased spouse’s half of the community property receive a step-up in basis, but the surviving spouse’s half does as well. This is often called a “double step-up.” For instance, if a couple in a community property state bought a home for $200,000 that is worth $1 million when one spouse dies, the surviving spouse’s new basis in the entire property becomes $1 million.

Valuation and Tax Reporting for Inherited Assets

Heirs must follow specific procedures for valuation and tax reporting when an inherited asset is eventually sold.

Determining Fair Market Value (FMV)

The step-up basis is the asset’s fair market value (FMV) on the date of the original owner’s death. For publicly traded securities like stocks, this value is determined by averaging the highest and lowest selling prices on that day. For real estate, a professional appraisal is the standard method for establishing FMV. The executor of the estate determines these values and may elect to use an “alternate valuation date,” which is six months after the date of death, if doing so would decrease the value of the gross estate and any estate tax due.

Reporting the Sale

When an heir sells an inherited asset, the transaction must be reported on their federal tax return. The sale is detailed on IRS Form 8949, Sales and Other Dispositions of Capital Assets, and the resulting gain or loss is summarized on Schedule D, Capital Gains and Losses. On Form 8949, the “Date Acquired” should be listed as “Inherited,” which qualifies the sale for long-term capital gains treatment, regardless of how long the heir held the asset. The cost basis entered is the stepped-up basis to calculate the taxable gain or loss.