What Is the Stock Step-Up in Basis at Death?

When an individual inherits assets like stocks or real estate, a tax provision known as the “step-up in basis” comes into play. This rule directly impacts the taxes an heir might owe when they eventually sell the inherited asset. The provision adjusts the asset’s cost basis, its original value for tax purposes, to its fair market value on the date the original owner passed away. This revaluation can significantly reduce the capital gains tax liability for the beneficiary.

How the Step-Up in Basis Works

To understand the step-up, one must first grasp “cost basis” and “fair market value.” The cost basis is what was originally paid for an asset, including any commissions or fees. Fair market value (FMV) is the price the asset would sell for on the open market on a specific date.

Consider an example where an investor buys stock for $10,000, which is their cost basis. At the time of the investor’s death, the stock is worth $100,000. The heir who inherits this stock receives it with a new, “stepped-up” basis of $100,000. If the heir sells the stock immediately for its market value, they would report no capital gain and owe no tax on the sale.

This treatment contrasts with assets transferred as gifts during the owner’s lifetime. In a gifting scenario, the recipient takes on the original owner’s cost basis, a situation known as “carryover basis.” If the $100,000 stock had been gifted before death, the recipient’s basis would remain at the original $10,000, triggering a taxable capital gain of $90,000 upon a sale.

The provision can also work in reverse, resulting in a “step-down” in basis. If an asset’s fair market value on the date of death is lower than the original cost basis, the heir’s basis is adjusted downward. For instance, if stock was purchased for $50,000 but is only worth $30,000 at the owner’s death, the heir’s basis becomes $30,000, which eliminates the ability to claim the $20,000 capital loss.

Assets Eligible for the Step-Up

The step-up in basis applies to a wide range of capital assets passed to heirs after death. This includes property like stocks, bonds, and mutual funds held in taxable brokerage accounts. Physical assets such as real estate, whether a primary residence or investment property, also qualify, as do valuable personal property like art collections, antiques, and precious metals.

Certain assets, however, are excluded from receiving a step-up in basis. The most common category is “Income in Respect of a Decedent” (IRD). These are assets that represent income the deceased person was entitled to but had not yet received and paid taxes on. The tax obligation passes to the beneficiary who receives the funds.

The most prevalent examples of IRD assets are retirement accounts funded with pre-tax dollars, including traditional IRAs, 401(k)s, 403(b)s, and most pension plans. When a beneficiary takes distributions from these inherited accounts, the entire amount is treated as ordinary income. Annuities also fall into this category, with the growth portion being taxable to the beneficiary.

Special Considerations and State Law Differences

The application of the step-up in basis can vary for a surviving spouse depending on state law, with a distinction between community property and common law states. In community property jurisdictions, assets acquired during the marriage are owned equally by both spouses. Upon the death of one spouse, both the deceased’s half and the surviving spouse’s half of the community property receive a full step-up in basis.

For example, if a couple in a community property state bought stock for $100,000 that is worth $500,000 when one spouse dies, the surviving spouse’s new basis for the entire holding becomes $500,000. In a common law state, only the deceased spouse’s share of the asset receives the step-up. In the same scenario, only the deceased’s 50% interest would be stepped-up, resulting in a new combined basis of $300,000.

Another rule allows the executor of an estate some flexibility in valuing the assets. Under Internal Revenue Code Section 2032, the executor can elect to use an “alternate valuation date” instead of the date of death, which is six months later. This election is only permissible if it results in a decrease in both the total value of the gross estate and the amount of federal estate tax owed. This can be a strategic choice if asset values decline in the six months following the owner’s death.

Determining and Reporting the Basis

An heir must determine and document the stepped-up basis before selling an inherited asset. The fair market value of a publicly traded stock on the date of death is calculated by averaging the highest and lowest selling prices on that day. This historical pricing data can be obtained from the brokerage firm that held the assets or through online financial data providers.

The responsibility for establishing this value falls to the executor of the estate, who is tasked with appraising all estate assets and reporting these values on the estate tax return, if one is required. Heirs should secure a copy of these valuation documents from the executor for their own records.

When the heir sells the asset, this stepped-up basis is used to calculate the capital gain or loss. This calculation is reported to the IRS on Form 8949, and the net result is then transferred to Schedule D of Form 1040. Brokerage firms that have been notified of the owner’s death will report this stepped-up basis on the annual Form 1099-B they issue.