Step-Up in Basis: How Inherited Assets Get a Tax Reset

Cost basis is the number the IRS uses to calculate taxable gain or loss when you sell an asset. Normally, basis is what you paid for something, adjusted for factors like reinvested dividends or capital improvements. But when an asset passes to an heir after the owner's death, tax law generally allows for a 'step-up' in basis: the asset's basis is reset to its fair market value on the date of death (or, in some cases, an alternate valuation date up to six months later, if the estate's executor elects it).

This matters enormously for anyone who inherits appreciated property. Consider a simplified example: someone buys shares for $10,000 decades ago, and by the time they pass away those shares are worth $100,000. If they had sold the shares themselves, they would owe capital gains tax on the $90,000 gain. But if their heir inherits the shares and the basis steps up to $100,000, the heir could sell immediately with little or no taxable gain, because the built-in appreciation during the original owner's lifetime is never taxed as a capital gain.

What Qualifies for a Step-Up

The step-up rule under Internal Revenue Code Section 1014 generally applies to property included in a decedent's gross estate for federal estate tax purposes, regardless of whether the estate actually owes estate tax. This commonly includes publicly traded stocks and bonds, mutual fund shares, real estate, and interests in closely held businesses.

• Individually owned brokerage accounts and real estate typically receive a full step-up to fair market value at death.
• Assets held in certain revocable ('living') trusts are usually still included in the grantor's estate and receive a step-up.
• Jointly owned property between spouses is treated differently depending on state law—see the community property distinction below.
• Life insurance proceeds are generally not subject to capital gains tax at all, so basis rules are less relevant there.

What Does Not Get a Step-Up

Not everything you inherit benefits from this reset. Tax-deferred retirement accounts, such as traditional IRAs, 401(k)s, and annuities, do not receive a step-up in basis, because withdrawals from these accounts are taxed as ordinary income rather than capital gains—the step-up concept doesn't apply to income that has never been taxed. Beneficiaries of these accounts are generally subject to distribution rules such as the SECURE Act's 10-year rule for most non-spouse beneficiaries, according to IRS guidance.

Lifetime gifts are another major exception. If someone gives you an asset while they're alive, you typically take on their original 'carryover' basis rather than a stepped-up one. This creates a meaningful tax planning distinction: transferring appreciated assets as a gift during life can leave the recipient facing a larger future capital gains bill than if the same asset had been left to them at death.

Community Property vs. Common-Law States

In common-law states, when one spouse dies, typically only that spouse's half of jointly owned property receives a step-up in basis; the surviving spouse's half retains its original basis. In community property states, however, IRS rules generally allow the entire asset—both the deceased and surviving spouse's shares—to receive a full step-up in basis, even though only half of the property technically changed hands. This can produce a significantly better tax outcome for the survivor, since selling the asset afterward could result in little or no taxable gain on the full value.

Step-Downs and Losses

The basis adjustment cuts both ways. If an asset has lost value since it was purchased, its basis is adjusted downward to the lower fair market value at death—a 'step-down.' This means any unrealized loss the original owner was holding disappears; heirs cannot use it to offset future gains. This is one reason some estate planners consider selling severely depreciated assets before death, so the original owner (or their estate) can capture the loss for tax purposes rather than losing it.

Basis rules are technical and the details can vary by asset type and state law. Anyone managing an inheritance or estate plan involving significant appreciated assets should consult IRS Publication 551 on basis of assets, along with a qualified tax professional or estate attorney, before making decisions. This article is for general information only and is not tax or legal advice.