How a step-up in basis changes the tax picture

When someone inherits property, U.S. tax law generally sets the beneficiary’s cost basis equal to the asset’s fair market value (FMV) at the decedent’s date of death. This is commonly called a “step-up” (or “step-down”) in basis and is governed by Internal Revenue Code Section 1014 and explained in IRS guidance (see IRS Publication 551). The practical result: if the heir sells the asset soon after inheriting, there may be little or no capital gain to tax.

Why this matters: capital gains taxes apply to the difference between sale price and cost basis. A stepped-up basis eliminates gains that accrued while the decedent owned the asset, which can shrink income tax and, in some cases, depreciation recapture for real property.

(Authoritative sources: IRS Publication 551—Basis of Assets, and guidance on estate and gift taxes; see irs.gov/publications/p551 and irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes.)

Common scenarios and specific rules

  • Inherited stocks and bonds: Beneficiaries normally receive a basis equal to FMV on date of death. If sold quickly, taxable gain is the difference between sale proceeds and that FMV.

  • Real estate and Depreciable property: Stepped-up basis applies, but sellers must still consider depreciation recapture rules (Sections 1245/1250). A step-up generally reduces recapture exposure because it raises the depreciable basis, but pre-death depreciation recapture may still apply for periods the decedent used the property in a trade or business.

  • Gifts made during life: Gifting does not usually create a step-up. The recipient generally takes the donor’s carryover basis (donor’s original basis), so transferring appreciated property by gift shifts unrealized gain to the donee.

  • Joint ownership and community property states: Rules differ. In community property states, a surviving spouse often receives a full step-up for the entire property; joint tenancy rules depend on how title was held. Check state law and consult counsel.

  • Alternate valuation date: For estate tax purposes, executors can sometimes elect an alternate valuation date six months after death (IRC §2032). That election affects estate tax calculations and can affect reported values, so coordinate with your estate tax advisor and appraiser before electing.

Key tax-planning trade-offs

  1. Income-tax benefit vs. estate-tax planning: A full step-up reduces capital gains for beneficiaries, but if your estate faces estate tax exposure, some lifetime gifting strategies (which remove assets from the estate) can reduce estate tax at the cost of giving up the step-up benefit for the gifted asset. Compare both taxes annually; consult your CPA or estate planner.

  2. Timing of sale: Selling inherited assets shortly after death typically locks in the step-up benefit. Delaying a sale lets the asset’s post-death gains or losses affect taxable results.

  3. Charitable strategies: Donating appreciated assets directly to a charity—or using a charitable remainder trust—can produce different tax outcomes. A charitable gift avoids capital gains, while a charitable remainder trust can convert appreciated assets into an income stream with tax-deferral.

Practical checklist for coordinating a sale with step-up planning

  • Confirm inclusion in estate: Verify the asset was included in the decedent’s gross estate. Most assets subject to probate or included via ownership rules receive the step-up.

  • Obtain a dated FMV: For real estate, get a written appraisal. For closely held business interests, consider a qualified business valuation. Documentation matters if the IRS questions your basis.

  • Consider immediate sale: If the goal is to eliminate capital gains on prior appreciation, selling soon after inheritance is the simplest strategy.

  • Check depreciation recapture exposure: For rental or business property, calculate potential ordinary-income recapture separately from capital gain.

  • Coordinate with estate tax filings: If Form 706 (estate tax return) is required, valuation and tax elections made by the executor can change effective tax outcomes. Work with a tax attorney or CPA.

  • Update cost-basis records with brokers: Provide estate documents to brokerage firms so Form 1099-B and cost-basis reporting reflect the stepped-up basis.

  • File sales reporting correctly: Reporting a sale of inherited property typically requires Form 8949 and Schedule D with supporting records; see IRS guidance on Form 8949 for details.

Real-world examples (simple calculations)

Example 1 — Stock sold soon after inheritance:

  • Original purchase price (decedent): $100,000
  • FMV at date of death (beneficiary basis): $400,000
  • Sale price three months later: $410,000
  • Taxable capital gain: $10,000 (sale price minus stepped-up basis)

Without step-up, gain would have been $310,000.

Example 2 — Rental house with prior depreciation:

  • Decedent’s original basis: $200,000; accumulated depreciation: $50,000; adjusted basis: $150,000
  • FMV at death (stepped-up basis): $350,000
  • If sold for $360,000, long-term capital gain = $10,000; depreciation recapture may be minimal because step-up raised basis above the adjusted (post-dep) basis.

These examples illustrate why proper valuation and timing can materially change tax outcomes.

Reporting and documentation

  • Form 8949 and Schedule D: Report sales of capital assets on Form 8949 and summarize on Schedule D. Enter the stepped-up basis as your cost basis. Keep appraisals, broker statements, and estate documents for at least three years beyond the filing date; retain longer if estate tax returns were filed.

  • Form 706 and executor responsibilities: If the estate is large enough to require Form 706, the executor’s valuation and elections can affect both estate and income tax outcomes. Work with a qualified estate tax specialist.

  • Broker reporting: Since broker cost-basis reporting rules require basis information for covered securities, give brokers correct documentation so Form 1099-B reflects the stepped-up basis.

(See IRS: About Form 8949 — https://www.irs.gov/forms-pubs/about-form-8949 and Publication 551 — https://www.irs.gov/publications/p551.)

Planning strategies and red flags

  • Avoid gifting appreciated assets to heirs with the expectation of a step-up: Gifts carry the donor’s basis forward, so the donee may face a large capital gain if they sell.

  • Trusts: Assets in revocable living trusts generally receive a step-up because they are included in the decedent’s estate. Irrevocable trusts depend on whether the assets are includible in the estate. Plan trust funding and terms with your estate planner.

  • Installment sales and seller-financed deals: If you sell property to a related party or on an installment basis before death, the tax outcome can be complex and may limit step-up opportunities.

  • Beware of valuation disputes: The IRS may challenge an appraisal. Use qualified, defensible valuation methods and retain documentation that supports FMV at death.

When a step-up isn’t the right tool

If the estate tax is the primary concern, lifetime gifting (to reduce estate size) may be preferable even though it sacrifices a future step-up for gifted assets. Likewise, when an owner wants heirs to have low basis (to preserve built-in-loss harvesting or basis step-down strategies), the planning can be different. These scenarios require a coordinated review of income tax, estate tax, and family goals.

Useful internal resources

Final takeaways and next steps

A step-up in basis is a powerful, well-established tax rule that can eliminate income tax on appreciation that accrued before a beneficiary owned an asset. The benefit is strongest when heirs sell shortly after inheritance, when accurate valuations are available, and when estate and income tax interactions are coordinated.

Always document FMV with qualified appraisals, coordinate timing with your tax advisor, and keep clear records for reporting. For complex estates, real property, or closely held businesses, consult a CPA and an estate attorney to align income-tax outcomes with the family’s estate-plan objectives.

Professional disclaimer: This article is educational only and does not constitute tax, investment, or legal advice. For guidance tailored to your situation, consult a qualified CPA or estate planning attorney.

Authoritative references