Step-Up In Basis Defined: How Does It Work?

When setting up an inheritance, taxes can be a tricky point to consider. Luckily, a step-up in basis can help anyone who inherits an asset save big on tax costs.

Ready to learn more about this possible way to save on taxes? Here’s what you need to know.

What is a step-up in basis?

A step-up in basis happens when an asset’s cost basis (or original price, plus associated fees) is reset to match the property’s fair market value (FMV) when an heir’s benefactor dies rather than when the asset was purchased. It is detailed in the Internal Revenue Code, §1014.

An example of how step-up in basis works

Let’s say that your uncle leaves you a home that he originally purchased for $100,000. When you inherited the property, it appreciated in value to $250,000. You would enjoy the tax benefits of a step-up in basis from $100,000 to $250,000.

If you decide to sell the property, this step-up in basis will significantly reduce your capital gains tax. Instead of paying capital gains taxes on the difference between $100,000 and the sales price, you would pay capital gains tax on the difference between $250,000 and the sales price.

Depending on your situation, a step-up in basis may save you thousands of dollars.

What is the capital gains tax?

To fully appreciate the benefits of a step-up in basis, it’s critical to understand capital gains tax. You pay capital gains tax on any asset worth more when sold than when you bought it.

Let’s say you bought a stock for $1, and it’s worth $5 when you sell it 2 years later. You would pay the long-term capital gains tax rate on the $4 you earned.

The length of time you hold on to an asset will affect your capital gains tax rate. When you own an asset for less than a year, you’ll be taxed at the short-term capital gains rate, which is your ordinary income tax rate.

You’ll pay the long-term capital gain rate, which can be between 0% — 20%, if you hold on to the asset for more than 1 year. The step-up in basis rule means that inherited property is always treated as a long-term capital gain opportunity.

Why does the IRS use the step-up in basis at death?

The Internal Revenue Service (IRS) chooses to use the fair market value at the time of a benefactor’s death. It’s used to determine the new value of the asset being transferred to help calculate the capital gains taxation of inherited properties.

According to the IRS, “the executor of a decedent's estate uses Form 706 to figure the estate tax imposed by chapter 11 of the Internal Revenue Code. This tax is levied on the entire taxable estate and not just on the share received by a particular beneficiary.”

With this clear distinction, the IRS can more easily assess taxes on estate and gifts.

Step-up in basis in estate planning

When it comes to estate planning, most people want to ensure their heirs will pay minimal taxes. Because of the step-up in basis, waiting to pass on valuable assets until after death can save beneficiaries money they might have to pay in capital gains tax if the assets are passed on while the original owner is still alive. This means that when possible, one ought to include their valuable assets, such as houses, businesses and antiques, in their will or a revocable trust.

Speak with a legal expert before planning your estate to ensure your heirs will get the most out of your assets. 

Aren’t primary residences exempt from the capital gains tax?

Have you heard that primary residences are exempt from capital gains tax? It’s true – up to a point. Individual taxpayers can exclude up to $250,000 of capital gains on the sale of a primary residence. Married couples filing jointly can exclude up to $500,000.

Examples of primary residence exemption

For example, let’s say that a married couple purchases a home for $150,000.

Ten years later, they sell the home that served as their primary residence for $300,000. The $150,000 in capital gains would be tax-exempt.

In another situation, let’s say a family purchases a home for $100,000. After 100 years, the home has appreciated to $3,000,000.

Over the years, the house has passed from family member to family member at the time of death. After inheriting the property with the significant step-up in basis, an heir could choose to sell the property to pay a minimal amount in capital gains taxes.

What if I don’t intend to sell the property?

When you inherit a property, you may not want to sell it. In that case, you won’t pay capital gains taxes, and your future heirs will enjoy the appreciation that the property builds. If your heirs decide to sell the property, under the law in its current form, this can postpone any taxable gains for generations to come.

Whenever an heir down the line chooses to sell, the seller will only pay capital gains taxes on the appreciation in the property’s value from the date of the owner’s death. The heir won’t pay capital gains taxes on the appreciation that occurred before they inherited the property.

Step-up in basis FAQs

Tax laws can be complex and challenging to comply with and understand. You’re certainly not alone—the majority of Americans are dissatisfied and confused by federal tax codes.

If you’re in doubt, you should speak to your financial advisor about whether you should accept a gift of property or the tax consequences of selling an inherited property.

Is the step-up basis optional?

A step-up in basis optional approach might be better given your situation. For example, heirs may opt out if they anticipate the value of the asset will decline after inheritance and prefer a different tax strategy.

Is the step-up in basis a tax loophole?

In the eyes of some, the step-up in basis option is a tax loophole. The rule allows an individual to pass down property to their heirs without paying taxes on its appreciation along the way.

What if the property suddenly depreciates in value?

If you inherit a property that suddenly depreciates, Section 2032 of the Internal Revenue Code allows for an alternate valuation of the adjusted cost basis (ACB). Under some circumstances, you can use the fair market value 6 months after the death if you decide to hold on to the property.

What about a step-up in basis after the death of a spouse?

Depending on your state, you may be able to inherit a spouse’s assets at fair market value on the date of their death.

What’s a non-community property state vs. a community property state?

In every state, but community property states, spouses are considered joint tenants with rights of survivorship (JTROS). The surviving spouse may receive a step-up in basis for half the property when their spouse dies. The other half of the increased value would be included in the deceased spouse’s estate.

If you live in a community property state, things work a little bit differently. When a spouse dies, a step-up in basis applies to both ownership portions of the property for the surviving spouse. If the surviving spouse decides to sell, they will save on capital gains taxes.

The bottom line on step-up in basis 

Capital gains taxes can be a major expense for beneficiaries. If you want to avoid capital gains taxes, inheriting an asset is preferred to receiving it as a gift.

Want to learn more about the tax implications of gifting? Check out our Learning Center.