Step-Up In Basis: What Is It And How Does It Work?

A step-up in basis occurs when the value of inherited assets readjusts to the current fair market value (FMV) for tax purposes. It’s a legal and commonly used tax strategy in estate planning that allows owners to leave capital assets to an heir who can avoid paying taxes on its appreciation.

A step-up in basis can apply to stocks, bonds, mutual funds and physical properties, like real estate. If you’ve recently inherited any of these financial assets, we’re going to cover everything you need to know to save on capital gains taxes.

Table of Contents:

• Understanding Stepped-Up Basis
• What Is Capital Gains Tax?
• Double Step-Up In Basis
• FAQs

Understanding Stepped-Up Basis

First, it’s important to understand cost basis, which is the original cost of an item before it appreciates in value. When financial assets appreciate and are sold, the seller is responsible for paying capital gains taxes on the difference between the current value and the cost basis from when it was acquired.

A stepped-up basis adjusts an inherited asset’s cost basis to its current value as of the decedent’s death date, so there’s no appreciation to pay taxes on if the asset’s recipient sells at its current value.

If the inherited asset is sold some time later, having appreciated further since its step-up in basis, the owner will pay taxes on the appreciation between the inherited value and current value, rather than its original cost basis.

Here’s a story example to help clarify:

Suppose your grandmother left you a piece of land she bought for $50,000. When she dies, you inherit the property, and it's now worth $150,000. In this case, you can receive a step-up in basis between $50,000 and $150,000.

That said, if you choose to sell the land, it will reduce your cost basis or capital gains tax. So you will pay capital gains taxes only on the difference between the fair market value price of $150,000 and the sale price of the property.

In other words, you won't have to pay capital gains taxes on the difference between her purchase price of $50,000 and today's value of $150,000. Using a step-up in basis can drastically lower your tax bill when it comes time to sell the property.

How Is It Calculated?

The step-up in basis is just the difference between the item’s current value and its cost basis at the time of purchase. So if you inherit a $150,000 property that was originally purchased for $50,000, the cost basis steps up $100,000 to the current value.

Capital gains tax is calculated based on this same difference if a step-up in basis doesn’t occur. So if your grandma were to give you the $150,000 property before she passes, a step-up in basis isn’t applicable and you’ll be responsible for the taxes on the $100,000 appreciation when the property is sold. 

What Happens If You Don’t Sell The Appreciated Assets?

If an heir chooses not to sell their inherited property, they’ll still receive the stepped-up cash basis, but they won’t have to pay capital gains taxes as long as they own the asset.

Instead, the asset can continue to pass on through generations, receiving a step-up in basis for each inheritance. This is a great way to build generational wealth without your descendants owing taxes.

What Is Capital Gains Tax?

A capital gains tax is a tax on an asset’s profit, which you pay when an asset’s fair market value is greater than the original purchase price.

Let's say you bought a stock for $1. When you decide to sell the stock 2 years later, its FMV is $5. With that, you would pay the long-term capital gains tax rate on the difference of $4.

The length of time that you hold onto the asset will affect your capital gains tax rate. You will be taxed at the short-term capital gains rate when you hold an asset for less than a year. Short-term capital gains are taxed at your ordinary income tax level.

But if you hold onto the asset for more than 1 year, you will pay the long-term capital gains rate, which can be either 0%, 15% or 20% (depending on your income and filing status). It’s worth noting that inherited property is always treated as a long-term capital gain opportunity.

Double Step-Up In Basis For Community Property

Step-up in basis rules are applied to community property differently, which affects widowed partners assuming their spouse’s stake of a shared property after death.

Most states will award a 50% step-up in basis to apply to the deceased partner’s share. So if a $100,000 property increased in value to $200,000, a step-up applies to 50% of the appreciation, bringing its cost basis to $150,000.

However, there are 9 states that recognize community property shared by a couple, and allow residents to apply a double step-up in basis rule that raises the cost basis to the current FMV. This includes a step-up for both the deceased and surviving spouse’s share of the asset.

In the example above, if the property was community property held in Arizona, the step-up would meet the full $200,000 current market value.

These community property states allow a double step-up in basis:

• Arizona
• California
• Idaho
• Louisiana
• New Mexico
• Nevada
• Texas
• Washington
• Wisconsin

Step-Up In Basis FAQs

Taxes can be complicated, especially when you apply the emotional process of managing inherited assets. The answers to these common questions can help steer you in the right direction for your step-up in basis.

Are Primary Residences Exempt From Capital Gains Taxes?

Primary residences are exempt from the capital gains tax up to a specific value based on your tax filing status. Individual taxpayers are exempt up to $250,000, and joint taxpayers are exempt up to $500,000. Any capital gains beyond these limits are subject to taxation.

For example, if you buy a home as a single adult for $150,000 and it appreciates to $400,000 in 15 years, the capital gains are $250,000. If you sell the house for $400,000, the first $150,00 of appreciation is exempt, but you will have to pay taxes on the remaining $100,000 appreciation.

Is Step-Up In Basis A Tax Loophole?

The tax provision isn’t technically a loophole, though it’s been criticized for disproportionately benefiting wealthy families and exacerbating the wealth gap. Supporters contest that the step-up in basis prevents double taxation and encourages Americans to save money and appreciating assets.

Recent efforts to soothe concerns include a proposal from President Biden in 2021 that would tax estates for unrealized capital gains exceeding $1 million per individual, regardless if the heir sells the asset. This proposal would also treat gifts and inheritance of appreciated property as a realization event, so capital gains taxes would be due at the time of transfer.

This proposal was not included in the Ways and Means Committee's 2021 tax package, and the step-up in basis clause is still active.

What Assets Don’t Get A Step-Up In Basis At Death?

Untaxed income, retirement savings and interest-bearing accounts aren’t eligible for a step-up in basis, including:

• 401(k) accounts
• IRAs
• Pensions
• Tax-deferred annuities
• Certificates of deposit
• Money market accounts

Gifts transferred prior to death and not included in inheritance are also ineligible for a step-up in basis.

How Does A Step-Up In Basis Work With Trusts?

Revocable and living trusts allow the grantor (the trust owner) to control the trust until the trust terms are fulfilled. Then, the property goes to the beneficiaries after the grantor’s death. Step-up in basis typically operates the same way as stated above.However, when it comes to irrevocable trusts, step-up in basis may work in several ways, since the method will depend on the structure and type of trust. For example, grantor trusts have different guidelines than non-grantor trusts.

Before you establish a trust, it's wise to speak with a financial advisor and estate planning attorney to guide you through all the ins and outs of the process. Partnering with professionals makes sure your trust fulfills your wishes after your passing and abides by federal and state laws.

The Bottom Line

Losing a loved one is painful. Receiving an inheritance in the midst of it all can be confusing and stressful. On top of that, capital gains taxes can eat away at the legacy your loved one left behind.

Understanding the tax rules such as the step-up in basis strategy can help you get the most out of your inheritance and minimize your tax bill when you’re ready to sell the assets. You may also want to consult with a financial advisor who can help you navigate the details of your inheritance.

And if you want to learn more about inheritance and estate planning, check out our Learning Center for more information about living trusts.