Step-Up in Basis

The step-up in basis is the rule that resets an inherited asset's cost basis to its fair market value at the date of death. The unrealized gain disappears: a stock bought at $100,000 and worth $900,000 when the owner dies passes to heirs with a $900,000 basis. If the heirs sell at $900,000, the capital gain is zero, and decades of appreciation never meet the IRS.

The rule interacts with the estate tax, which taxes the estate itself above the exemption. The step-up applies to inherited homes, stocks, funds, and most capital assets; retirement accounts are the exception, because IRA and 401(k) money is taxed as ordinary income to heirs regardless of basis. Community-property states double the gift: both halves of a jointly owned asset step up at the first death.

The mechanics run on the date of death. The executor values every capital asset at fair market value on that date, and the heir's basis becomes that value, not the decedent's purchase price. A portfolio bought for $200,000 and worth $1.1 million at death passes with a $1.1 million basis: the heir who sells immediately owes nothing, and the heir who sells at $1.2 million owes capital gains on $100,000, not $1 million.

The exceptions are the fine print. Retirement accounts step down to ordinary income treatment: inherited IRA and 401(k) money is taxed to the beneficiary as withdrawn, and the 10-year rule now governs most non-spouse heirs. Assets gifted during life carry the donor's basis instead, which is the holding-versus-gifting decision: appreciated stock gifted to a child transfers the gain, while the same stock inherited erases it.

Community property is the doubled version. In the nine community-property states, California and Texas among them, both halves of a jointly owned asset receive a step-up at the first death, so the surviving spouse's half also resets. The carryover basis that applies to lifetime gifts is the rule the step-up replaces at death, and the estate files Form 706, where the valuation is the number every heir's return reads.

The step-up is the reason appreciated stock almost never pays both capital gains and estate tax, and it is the largest erasure in the code. The holding-versus-gifting decision prices every family transfer: appreciated assets are better inherited than gifted, and low-basis assets are the reverse. The retirement-account exception is where most families meet the rule's limits.

I watched a colleague named Brent (yes, that Brent) gift his $400,000 of appreciated stock to his mother during her final year, expecting the estate to save the tax. Lifetime gifts carry his basis to the recipient, and the estate lost the step-up the inheritance would have given; the stock was sold inside a year at a $300,000 gain, taxed to the recipient. The step-up was the tax plan he declined by gifting.

The highest-leverage thing most American families can do is inherit appreciated assets rather than gift them, and leave retirement accounts to the 10-year rule with a plan. Read the estate side in the estate tax entry, the inherited-account rules in the inherited IRA entry, and size the exposure with the estate tax calculator.