The Step-Up in Basis Rule: How It Works and Why It Matters for Inherited Assets
CORE INSIGHTS
- The Tax Magic: The Step-Up in Basis rule resets the cost basis of inherited assets to their market value on the date of death, erasing decades of capital gains.
- Asset Location: This powerful benefit applies only to taxable brokerage accounts and real estate, not to tax-deferred retirement accounts like IRAs.
- Legacy Strategy: Smart estate planning involves holding appreciated taxable assets until death to pass them on tax-free, while spending down retirement accounts first.
Estate planning requires mastering one of the most potent tax advantages in the U.S. code: the Step-Up in Basis. When an appreciated asset—such as a stock portfolio or primary residence—is inherited, its cost basis is “stepped up” to its fair market value on the date of the original owner’s death. This effectively shields heirs from paying Capital Gains Tax on appreciation that occurred during the decedent’s lifetime.
Fair Market Value (FMV): The price an asset would sell for on the open market today.
Imagine buying a stock for $10,000 that grows to $100,000.
• Owner Sells (Alive): Taxable gain is $90,000. Capital gains tax is owed.
• Heir Sells (After Death): Basis resets to $100,000. If sold for $100,000, taxable gain is $0.
Result: The family saves thousands in taxes by simply holding the asset until death.
Visualizing the Tax Liability
Data illustrates the profound difference in tax liability between selling an appreciated asset during your lifetime versus passing it on to heirs.
*Figure 1: Comparison of taxable gains. The Step-Up rule effectively erases the tax liability for the heir.*
Comparison: Brokerage vs. Retirement Accounts
| Account Type | Step-Up Rule Applies? | Tax Result for Heirs |
|---|---|---|
| Taxable Brokerage | Yes | Capital Gains tax on appreciation is eliminated. |
| Traditional IRA / 401(k) | No | Withdrawals are fully taxed as ordinary income. |
| Real Estate | Yes | Home value resets, minimizing taxes on a future sale. |
Strategic Action Steps
Identify highly appreciated assets held in taxable accounts. These are prime candidates for the Step-Up rule and should be the last assets you sell for income.
Since Traditional IRAs do not receive a step-up and are taxed upon withdrawal by heirs, consider spending down these accounts first during retirement.
Upon the death of the owner, executors must document the Fair Market Value of all assets to establish the new cost basis for heirs.
The Bottom Line: Legacy Planning
- Hold: Highly appreciated stocks or real estate in taxable accounts to maximize the Step-Up benefit.
- Sell/Spend: Assets in tax-deferred accounts or assets with little to no appreciation (high basis).
Frequently Asked Questions
It depends on state law. In community property states, both halves of the asset may get a full step-up. In common law states, typically only the decedent’s half gets the step-up.
Yes, unfortunately. If an asset has lost value (Step-Down), the basis is reset to the lower market value, eliminating the ability for heirs to claim a capital loss deduction.
The Step-Up in Basis is a permanent part of the current tax code, but it is frequently debated in Congress as a potential revenue source. Always monitor tax law changes.