Overview

Wealth transfers raise three linked tax questions: what is the asset’s tax basis, does the asset receive a step‑up (or step‑down) in basis at death, and what reporting or returns must be filed by the decedent’s estate or by heirs when assets are sold. These outcomes drive potential capital gains liability for heirs and can influence decisions about gifting, trusts, and timing of transfers.

This article explains the rules that commonly apply to stocks, bonds, real estate, business interests, and retirement accounts; identifies reporting responsibilities for executors, estates, and beneficiaries; and highlights practical planning points and common mistakes. For focused definitions and related topics, see FinHelp’s pages on “Step‑Up in Basis” and “Basis of Inherited Property Explained“.

How basis and step‑up work (practical mechanics)

  • Basis: The tax basis is the amount used to determine gain or loss when an asset is sold. For a purchased asset, basis generally equals purchase price plus capital improvements and certain acquisition costs (see IRS Publication 551).
  • Step‑up (or step‑down) at death: In most cases when property is inherited, the beneficiary’s basis becomes the fair market value (FMV) at the decedent’s date of death. This means unrealized gains that accumulated during the decedent’s ownership are not taxed to the heir when they receive the asset — only gains after the date‑of‑death FMV are taxed when the heir sells.
  • Alternate valuation: If an estate files Form 706 (estate tax return), the estate may (under limited conditions) elect an alternate valuation date six months after death to value assets. This election can change the stepped basis used for estate tax valuation; it is complex and should be evaluated with a tax professional (IRS Form 706 instructions).

Example calculation

  • Decedent bought stock for $10,000 (basis). At death the stock’s FMV is $100,000. The heir’s basis is $100,000 (step‑up). If the heir sells immediately at $100,000, there is no capital gain. If the heir later sells at $130,000, capital gain is $30,000 (sale price minus stepped‑up basis).

Contrast with lifetime gift

  • A gift during the donor’s lifetime generally transfers the donor’s basis (carryover basis) to the recipient. If the donor’s basis was low, the recipient inherits that low basis and may owe sizable capital gains tax upon sale. Lifetime gifts avoid a death‑time step‑up except in narrow community property situations — consult counsel.

Special asset categories and exceptions

  • Retirement accounts: Inherited IRAs and other qualified plans do not receive a step‑up in basis because those accounts are tax‑deferred and taxed on distribution. Recent law changes (e.g., the SECURE Act) created a 10‑year rule for many non‑spouse beneficiaries; rules vary by beneficiary type and plan — review plan and IRS guidance for current rules.
  • Depreciated business or rental property: For most inherited business or rental property, the step‑up wipes out the decedent’s accumulated unrealized gain and prior depreciation is not recaptured based on the decedent’s use. However, depreciation and cost recovery rules apply to the heir’s future use of the property. Consult Publication 551 and a tax advisor for asset‑specific questions.
  • Community property states: Community property rules can produce a full step‑up for both spouses’ halves on the death of one spouse in some states. State law nuances matter — discuss with local counsel.

Reporting responsibilities (what gets filed and when)

  • Final individual income tax return: The decedent’s final Form 1040 must be filed for the year of death reporting income up to the date of death.
  • Estate income tax (Form 1041): If the estate generates income after death (e.g., interest, dividends, rental), the estate may need to file Form 1041 and pay income tax on that income.
  • Estate tax return (Form 706): If the gross estate exceeds federal filing thresholds (which are adjusted annually), the executor files Form 706. Filing Form 706 impacts estate tax and can affect valuation choices; consult IRS estate and gift tax guidance.
  • Capital gains reporting by heirs: When heirs sell inherited assets, they report capital gains on their individual returns (Schedule D and Form 8949) using the stepped‑up basis. Maintain records proving the FMV at date of death.

Useful IRS sources: Publication 551 (Basis of Assets), the IRS estate and gift tax pages, and instructions for Form 706 and Form 1041 (irs.gov).

Documentation and valuation — practical checklist for executors and heirs

  1. Obtain reliable FMV evidence at date of death: broker statements, county property appraisal for real estate, third‑party appraisals for unusual assets (art, business interests).
  2. Preserve purchase records and improvement receipts; heirs need these if the basis is carryover (e.g., lifetime gifts) or when computing post‑death capital improvements.
  3. Keep estate tax filings and appraisals if Form 706 is filed — these support basis determinations and defend against later IRS inquiries.
  4. Coordinate with custodians: Transfer ownership and obtain corrected cost‑basis reports from brokerages where necessary.

Common mistakes and pitfalls

  • Assuming everything gets a step‑up: Retirement accounts, some gifted property, and certain trust arrangements do not automatically receive a step‑up.
  • Poor valuation documentation: Weak or missing appraisals trigger IRS adjustments and disputes — invest in credible valuations for high‑value or illiquid assets.
  • Gifting to avoid estate tax without modeling income tax consequences: Lifetime gifting can create large capital gains for recipients if the donor’s basis is low; always run numerical scenarios.
  • Ignoring state tax rules: State estate, inheritance, and capital gains tax rules vary and may create liabilities even if there’s no federal tax.

Practical planning strategies (high‑level)

  • Use trusts thoughtfully: Marital trusts, credit shelter trusts, and certain grantor trusts can control timing and character of recognition, but each has trade‑offs for basis and estate tax. See FinHelp’s article on “Wealth Transfer — Tax Basis Strategies for Transferring Real Estate to Family” for real‑estate‑specific techniques.
  • Consider qualified disclaimers: A beneficiary can disclaim an inheritance in favor of others in some situations, which can affect who receives a stepped basis.
  • Coordinate liquidity for estate taxes: If an estate could owe federal or state estate tax, plan for cash to pay taxes rather than forcing a distressed asset sale.
  • Track cost basis during life: For households with multiple accounts and legacy holdings, tracking basis data prevents surprises later; see FinHelp’s guide on “Best Practices for Tracking Cost Basis on Investments and Real Estate“.

Who is most affected

Anyone inheriting assets can be affected, but stakes are highest for owners of highly appreciated assets (real estate, stock concentrated positions, business interests) and estates near or above federal and state estate tax thresholds. Executors, trustees, and beneficiaries all play roles in valuing assets and meeting filing requirements.

Frequently asked clarifications

  • Step‑up vs carryover: Inheritance usually gives a stepped‑up basis; lifetime gifts generally pass carryover basis. The difference can be decisive for ultimate tax bills.
  • Do heirs ever get taxed at death on capital gains? Generally no — capital gains are realized and taxed when assets are sold, not when inherited. Exceptions and complex rules (estate tax inclusion, certain trusts) can alter outcomes.
  • Is the step‑up permanent? Yes — the heir’s basis is set at date‑of‑death FMV. Future gains are computed from that new basis.

Final practical notes and next steps

Executors should assemble basis and valuation records early, consult appraisers for high‑value assets, and meet with a tax advisor before making distributions or selling significant inherited property. Beneficiaries should request documentation of basis from the estate or trustee and get professional advice before selling or gifting inherited assets.

This article summarizes general rules and examples. Individual outcomes depend on specific facts, state law, and current federal rules. For official IRS publications, see Publication 551 (Basis of Assets) and the IRS estate and gift tax guidance (irs.gov). For personalized planning, consult a qualified tax advisor or estate attorney.

Disclaimer: This content is for educational purposes and does not constitute tax, legal, or financial advice. Always consult a qualified professional about your specific situation.

Authoritative resources

Related FinHelp glossary pages