Do You Know What Is a Step-up in Cost Basis, and How MayAffect You?

You can decrease your tax liability for inherited property through successful planning and proper methods.

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Key Takeaways

• The tax basis of property acquired by a beneficiary from someone who dies is ordinarily the property’s fair market value at the date of the decedent’s death. The adjustment can either be an increase, known as a step-up in basis, or a decrease in the basis, depending on the value at the date of death.
• The beneficiary must calculate capital gains and losses from the inherited asset when they sell it by subtracting its adjusted basis from its selling price. Taxable brokerage accounts commonly hold real estate and investment assets that undergo basis adjustments.
• Surviving spouses in community property states receive a step-up in basis for both halves of their shared community property.

What Is a Step-up in Basis?

Under Section 1014 of the Internal Revenue Code, a person who dies while owning property will receive a new basis that matches the fair market value of the property at their time of death. People can inherit assets such as stocks or real estate through this rule without facing capital gains tax obligations. In community property states, married couples gain significant advantages.

The Internal Revenue Service allows inheritors to hold the asset for an extended period, which enables them to pay lower long-term capital gains taxes instead of higher short-term rates.

How Does Step-up in Basis Work?

All assets have a cost basis, which is more or less their purchase price. The sale of an asset results in capital gain or loss based on the sale price minus the cost basis. Capital gains are subject to taxes. The cost basis of an inherited asset typically receives a “step up” to fair market value at the time of the individual’s death. The asset functions as though it were purchased at the original sale price, which the investor received because no tax needs to be paid on unrealized gains.

How Is the Step-up in Cost Basis Calculated?

The cost basis of an asset comes from its purchase price, which requires additional adjustments to determine its final value. The cost basis of real estate increases when the owner makes substantial improvements or renovations. Any fees or commissions you pay to acquire stocks will increase your cost basis, whereas investment management fees do not affect your cost basis.

Inheritors of an asset that qualifies for a stepped-up basis can establish the new cost basis at the current fair market value. The beneficiary must recognize capital gain that emerged between the original purchase and the owner’s death, but it can remain uncollected. The asset contains all non-taxable value, which will become taxable only when the asset is sold. When the inheritor sells their inherited property, any increase in value since the inheritance will be subject to taxation.

The estate tax return enables an executor to choose an alternate valuation date, which comes six months after the date of death. The alternate valuation date applies when an asset loses value from its death date, proceeds to follow that value to determine adjusted basis.

Example of a Step-up in Cost Basis

Angela, who inherited a home that she bought for $50,000 in 1975, passed away in 2020. Over the past 45 years, her home value increased to ten times its original value, reaching $500,000. The home became her daughter Mary’s inheritance according to her will.

Mary received the home through inheritance, which resulted in a new cost basis that matched the home’s market value at her mother’s death, which was $500,000. The home sale occurred two years later at a price of $525,000. The capital gain for her amounted to $25,000.

The step-up in cost basis rule enabled Mary to receive the house with an adjusted cost basis that reflected its current market value at the time of her mother’s death, which was $500,000. The total capital gain for her reached $475,000 because she sold the house after her mother purchased it for $50,000.

Mary would face capital gains taxes totaling about $95,000 under a federal capital gains tax rate of 15% combined with a state tax rate of 5% based on her annual income of $50,000 and her capital gains. Mary would have obtained a $250,000 capital gain exclusion if she moved into the inherited home and it had become her main residence for at least 2 years. Her tax bill amounted to around $45,000 because she qualified for the capital gain exclusion, yet she did not receive the step-up.

The step-up in basis allowed Mary to save $50,000 in taxes for her inherited assets.

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What Assets Are Subject to Step-up in Basis?

Assets that receive a step-up in basis when they pass to a beneficiary include:

• Real estate
• Individual stocks or bonds
• Mutual funds 
• Art and furnishings 
• Collectibles 
• Some business interests 

Note: Assets such as the above passing to an heir from an irrevocable trust may not be eligible for a step-up in cost basis.

What Assets Are Not Subject to Step-up in Basis?

Assets that do not receive a step-up in basis when they pass to a beneficiary include:

• Bank accounts 
• Cash 
• Certificates of deposit 
• 401(k)s and other employer-sponsored retirement plans 
• IRAs 
• Pensions 
• Annuities 

When you inherit one of these assets, you retain the original owner’s cost basis.

How Does a Step-up in Cost Basis Affect Capital Gains Rates?

Capital gains tax rates depend on two separate federal tax tables because the duration an asset remains held before its sale determines which table applies to it.

Profits from the sale of assets held for a year or less are classified as short-term capital gains and taxed at your federal income tax rate. Profits from the sale of assets held for more than a year are long-term capital gains and taxed at a potentially lower rate, at either 0%, 15%, or 20% (collectibles can be taxed up to 28%). The rate you pay depends on your taxable income. You may also be subject to the 3.8% Net Investment Income Tax (NIIT) if your income exceeds certain thresholds.

The inheritance of assets automatically grants you long-term capital gains tax rates, which apply to all cases regardless of how long the original owner held the asset.

Long-term capital gains tax rate 2025

Source: IRS

Final Thoughts

The step-up in basis system allows recipients to reduce their tax obligations while ensuring that their inherited property is correctly processed. The adjusted cost basis operates as a fundamental requirement for determining capital gains precisely from all types of investment assets, which include real estate and stocks. To achieve correct property valuation for your inherited assets, which will help you obtain maximum tax advantages, you should reach out to us at Meridian Property Appraisers in St. Pete, who will provide our expert property valuation services.

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