Step-up in basis defined: How does it work?

A step-up in basis can offer a significant tax break to heirs in the form of lower capital gains taxes. Essentially, this tax rule resets an inherited asset’s value to its market value at the owner’s death.

If you plan on leaving a property to your heirs or expect to inherit a property, understanding how a step-up in basis works can come in handy.

What is a step-up in basis?

A step-up in basis occurs when an heir inherits an asset, according to the Code of Federal Regulations. When ownership of the asset passes from the deceased to the heir, the cost basis of the inherited asset resets to the current fair market value (FMV).

Generally, a step-up in basis allows the heir to limit their capital gains taxes when selling the asset after a benefactor’s death.

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. By the time you inherited the property, it had appreciated to a value of $250,000. As the heir, your cost basis would step up to the fair market value at the time of your inheritance. In this case, that would be $250,000.

If you decide to sell the property, this step-up in basis would 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.

Community property states

If you live in a community property state, most property bought or received during a marriage is jointly owned. When one spouse dies, the entire property tends to receive a full step-up in basis for the surviving spouse.

Let’s say married couple Dave and Alice are living in a community property state. If Dave dies, Alice, the surviving spouse, will receive a full step-up in basis. When the house they bought originally for $500,000 received a step up in value to the current fair market value of $700,000, Alice could potentially save on capital gains taxes if she chooses to sell.

In contrast, surviving spouses living in non-community property states will typically only receive a step-up in basis for the deceased spouse’s share of the property.

How step-up in basis affects capital gains tax

You pay capital gains tax on any asset worth more when sold than when you bought it.

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. Notably, inherited property is always treated as a long-term capital gain opportunity.

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.

If you sell an inherited property, the step-up in basis can significantly impact your tax obligations. By increasing your cost basis, you’ll potentially face lower capital gains tax liabilities when selling inherited property.

Step-up in basis in estate planning

If building an estate plan, most prefer to build a plan that minimizes the tax burden on their heirs. With this rule in mind, many benefactors wait to pass on valuable assets until after their death so that their heirs can enjoy the step-up in basis.

The ability to minimize an heir's tax burden can be a game-changer for many families. But the downside is that waiting to pass on assets can complicate gift giving and potentially create uncomfortable family interactions.

For example, if planning to pass down your primary residence to your child, waiting until your death to legally change over ownership could make for a complicated co-mingling of finances for years or decades. As you consider your estate plans, make sure to talk to a legal expert to map out the best choices for you and your heirs.

What if you 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.

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 preceding owner’s death. The heir won’t pay capital gains taxes on the appreciation that occurred before they inherited the property.

FAQ about the step-up in basis

As you explore your options, the following answers about a step-up in basis may help.

Is the step-up basis optional?

Yes, heirs can choose to opt out if another tax strategy makes more sense.

Can the step-up in basis be seen as a tax loophole?

In the eyes of some, the ability to step up in basis 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.

Why is the step-up in basis controversial?

Some see this as a loophole for the wealthy. Lawmakers have proposed taxing inherited gains. But so far, these changes haven’t passed, and many defend the rule to protect family assets.

What if the property suddenly depreciates in value?

You can use an alternate valuation based on fair market value 6 months after death under Section 2032 of the IRS code.

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

Some states allow a surviving spouse to inherit a deceased spouse’s assets at their fair market value at the time of death.

Are primary residences exempt from the capital gains tax?

Primary residences can be partially exempt from capital gains tax (up to $250,000 for individuals or $500,000 for married couples). A step-up in basis can further reduce taxes on inherited homes.

The bottom line: Step-up in basis can reduce the tax burden for your loved ones

When an heir inherits the property, the step-up in basis can help to minimize capital gains taxes during a sale. Many families can appreciate the potential cost savings involved.

As you explore your estate plans, learning more about the potential tax implications of gifting can help you make informed decisions.

This article is for informational purposes only and is not intended to provide financial, investment, or tax advice. You should consult a qualified financial or tax professional before making decisions regarding your retirement funds or mortgage.