What Is the Step-Up in Basis One-Year Rule?

The tax basis of inherited property is generally “stepped-up” to the asset’s fair market value at the time of the owner’s death, a provision that can reduce the capital gains tax an heir owes upon selling the asset. However, specific exceptions exist that can prevent this favorable tax treatment. These rules are designed to address situations where the standard step-up rule would create an unintended tax loophole.

The General Rule of Step-Up in Basis

An asset’s cost basis is what an individual paid to acquire it, including commissions or fees. When an asset is sold, the taxable capital gain is the sale price minus the basis. The step-up in basis rule, found in Internal Revenue Code (IRC) Section 1014, adjusts this for inherited property by resetting the basis to its fair market value on the owner’s date of death.

This adjustment means appreciation during the decedent’s lifetime is not subject to capital gains tax for the heir. For example, if an individual purchased stock for $10,000 and it is worth $100,000 on the day they die, the heir receives a new basis of $100,000. If the heir immediately sells the stock for $100,000, there is no capital gain to report, as the $90,000 increase in value is erased for tax purposes.

This mechanism applies to assets like real estate, stocks, and other valuable property. Its purpose is to prevent heirs from needing to track an asset’s basis over many decades. The rule provides a clean slate, basing future taxable gains only on the value from the date of inheritance forward.

The One-Year Rule Exception

A provision in the tax code, Section 1014(e), creates an exception to the step-up rule, often called the “one-year rule” or “boomerang rule.” It was enacted to prevent a tax strategy where someone transfers appreciated property to a person near death, expecting to inherit it back with a stepped-up basis. This would allow the original owner to avoid capital gains tax on a future sale.

For the one-year rule to negate the step-up in basis, three conditions must be met. First, the property must have been acquired by the decedent as a gift within the one-year period ending on their date of death. Second, the same property must pass from the decedent back to the original donor or the donor’s spouse. If any of these conditions are absent, the exception is not triggered, and the standard step-up in basis rule applies.

Determining the Basis When the Rule Applies

When the one-year rule is triggered, the step-up in basis is denied. Instead, the property is subject to a “carryover basis,” meaning the heir who receives the property back does not get a new basis equal to the fair market value at death. The heir must “carry over” the basis that the decedent had in the property.

The decedent’s basis is the original donor’s adjusted basis at the time of the gift. Consequently, the original donor reacquires the property with the same basis they had before the gift was made. This nullifies the tax benefit of eliminating the built-in capital gain.

For example, an individual owns stock with a basis of $10,000 and gifts it to a relative when it is worth $95,000. The relative dies six months later when the stock is worth $100,000 and leaves it back to the original donor. Because all conditions of the one-year rule are met, the step-up is denied, and the donor’s basis remains their original $10,000. A sale of the stock for $100,000 would result in a $90,000 taxable capital gain.

Scenarios Where the One-Year Rule Does Not Apply

There are several situations where the one-year rule is not applicable, allowing the standard step-up in basis. The most straightforward scenario is when the recipient of the gift lives for more than one year after receiving it. If the decedent survives beyond this one-year window, the rule does not apply, and the heir will receive a full step-up in basis.

Another exception involves who inherits the property. If the decedent bequeaths the appreciated property to anyone other than the original donor or the donor’s spouse, the rule is not triggered for that heir. For instance, if a parent gifts stock to a child who dies within a year but leaves it to a grandchild, the grandchild would receive a full step-up in basis.

A nuance exists if the decedent’s estate handles the property. If the estate sells the appreciated property and distributes the cash proceeds to the original donor, the one-year rule still applies. The estate is denied the step-up in basis when calculating its gain on the sale, preventing a workaround where the asset is converted to cash before being returned.