Step-Up in Basis

A step-up in basis is a tax provision that adjusts the cost basis of an inherited asset to its fair market value (FMV) on the decedent’s date of death. This reset can substantially reduce or eliminate capital gains taxes that heirs would otherwise owe when they sell the asset.

How it works

• Original cost basis = purchase price plus adjustments (improvements, depreciation adjustments, etc.).
• At the owner’s death, the basis is “stepped up” (or “stepped down” if FMV is lower) to the asset’s FMV on that date.
• When an heir later sells the asset, capital gain = sale price − stepped-up basis. If sold at or near FMV, little or no capital gain tax is due.

Example: Jane bought a stock for $2, which is worth $15 when she dies. The heir’s basis becomes $15. The $13 gain that accrued during Jane’s ownership is not taxed when the heir sells at $15.

Applicable assets include stocks, bonds, mutual funds, real estate, and other tangible property.

Community property and the double step-up

In the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin), community property generally receives a double step-up: the entire community property can be revalued to FMV at the first spouse’s death, not just the deceased spouse’s half. This can eliminate built-in gains on the full value of community assets.

In common-law states, only the deceased spouse’s share typically receives a step-up. For example, a jointly held asset worth $200,000 with a $100,000 total basis might receive only a $50,000 step-up (the deceased’s half), leaving the surviving spouse with a $150,000 basis rather than $200,000.

Some states (e.g., Alaska, Kentucky, South Dakota, Tennessee) allow community property trusts that can provide community property tax treatment, including the double step-up, under federal rules.

Tax impact and controversy

• Critics view the step-up in basis as a tax loophole that disproportionately benefits wealthy households. Analyses (e.g., by the Congressional Budget Office) show a large share of the benefit goes to top-income taxpayers.
• Estimates of federal revenue forgone due to the provision run into tens of billions of dollars annually.
• Supporters argue that eliminating the step-up could discourage saving and create double taxation when combined with estate taxes. Proposals to limit or repeal the provision (including a 2021 proposal for high-value estates) have not passed Congress.

Practical considerations for heirs

• Document the FMV at death (appraisals for real estate or closely held business interests; brokerage records for marketable securities).
• Joint ownership, community property status, and how property passes (will, trust, joint tenancy) affect the basis outcome.
• If FMV at death is lower than the decedent’s basis, heirs may inherit a stepped-down basis and could realize a loss when selling.
• Consult a tax professional for valuation issues, filing requirements, and estate tax interactions.

Key takeaways

• A step-up in basis resets an inherited asset’s tax basis to its FMV at the decedent’s death, often reducing capital gains taxes for heirs.
• Community property rules can produce a double step-up for surviving spouses in qualifying states or trusts.
• The provision is politically controversial because it benefits those who inherit appreciated assets—often high-net-worth households.
• Proper documentation and professional advice help heirs use the provision correctly and minimize tax surprises.

Sources

• Internal Revenue Service, Publication 551: Basis of Assets; Topic No. 703, Basis of Assets
• Congressional Budget Office analyses of tax expenditure distribution
• Tax Foundation and Peter G. Peterson Foundation reports on step-up in basis and federal revenue impacts
• Kitces (tax planning for preserving/loss assets) and resources on community property trusts