When planning for your estate or inheriting property from someone else, several important factors come into play. One of these is cost basis, which typically refers to the amount paid to acquire an asset, such as a house. Cost basis matters when you sell an asset because it determines the profit or loss you’ll incur from the sale – and how much capital gains tax you’ll owe, if any. (Note that basis may include capital improvements and other costs in addition to the original purchase price.)
When individuals leave assets to heirs, the IRS adjusts the cost basis of inherited property to its current fair market value (FMV), which often results in tax benefits. Importantly, this is not the case for gifts – the tax basis of a gift in the hands of the recipient is the same as the basis in the hands of the giver. In this article, we’re focusing on transfers of assets at someone’s death.
Read on to learn more about how a step-up in cost basis works and why it’s important for tax and estate planning.
A step-up in basis refers to a U.S. federal tax law that allows the cost basis of inherited property to be updated to its current FMV, typically on the previous owner’s date of death.
If an heir then sells that inherited property, the amount of capital gain that is subject to tax is calculated by subtracting the stepped-up cost basis from the sale price. As a result, the heir generally doesn’t owe capital gains tax on the appreciation that occurred during the decedent’s lifetime
The step-up in cost basis rule plays a key role in estate and tax planning because it can significantly reduce or even eliminate capital gains taxes when heirs inherit appreciated assets. In contrast, if appreciated property is gifted during an owner’s lifetime, the original cost basis stays with the asset and often triggers a capital gains tax bill on a later sale. And if the original owner sells the asset, the owner will pay tax if the sale price is higher than the cost basis.
Suppose your parents bought a $300,000 home that appreciated to $700,000 by the time of their death. If they leave it to you, the step-up in basis rule would set your cost basis of the home at $700,000. As a result, if you sell the property for $700,000, your taxable gain would be $0 instead of $400,000. Assuming a federal long-term capital gains tax of 15%, the step-up in basis would save you $60,000 in capital gains taxes.
The step-up in cost basis rule generally applies to all property inherited from a decedent. For example, real estate, individual stocks and bonds, ETFs (exchange-traded funds) and mutual funds, collectibles, personal use items and even some business interests are all eligible.
However, not every asset’s basis is stepped up. Bank accounts and cash never experience gains, and the tax basis is always equal to the market value. Tax-advantaged accounts – such as 401(k)s, traditional IRAs (individual retirement accounts), pensions and annuities – also don’t receive a stepped-up basis and follow different rules when payments are made to beneficiaries (income from these assets is usually taxed as ordinary income).
Additionally, there’s an exception to note when it comes to setting the updated FMV of inherited assets. If the executor of a person’s estate files an estate tax return, the executor may choose to value the estate using an alternate valuation date (AVD), which falls six months after the person’s date of death. However, this election is allowed only if the AVD reduces the gross estate value and net estate taxes.
Marital property refers to assets acquired during a marriage. When one spouse dies, a couple’s shared assets are assigned a step-up in basis according to the laws of the state or how they hold title to the assets (whether in the name of one spouse or both). Most states are common law states, but some are community property states.
Community property is a legal concept that gives spouses equal ownership of property acquired during a marriage – regardless of who earned it and regardless of who nominally owns it. The nine U.S. states with mandatory community property laws for married individuals are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. (Additional community property laws also apply to registered domestic partners in California, Nevada and Washington, and certain states like Tennessee, Florida, Alaska, Kentucky and South Dakota allow opting in to community property treatment in some cases.) The remaining 41 common law (non-community property) states generally follow the default step-up in basis rules based on who owns the property.
In community property states, surviving spouses receive a step-up in basis on the entire amount of community property, as long as at least half of the community property interest is included in the deceased spouse’s gross estate. For example, if Ann and Dave bought a $150,000 home that’s worth $400,000 at the time of Dave’s death, the basis of the home is stepped up to the $400,000 FMV. As a result, if Ann sold the house for $400,000, she would show a $0 profit, and the sale wouldn’t lead to any capital gains tax liability.
Another benefit is the “double” step-up available as a result of this rule. If Ann dies when the house is worth $600,000, her heirs get another step-up to $600,000, so they could then sell with no capital gains tax liability.
In common law states, only the deceased spouse’s share of jointly owned property is adjusted to its current FMV on the date of their death. The surviving spouse retains their original cost basis, which results in a partial step-up.
If the deceased spouse was the sole owner of a couple’s assets, all the assets would be entitled to a step-up. On the contrary, if the surviving spouse owned all the assets, no step-up would be available upon the deceased spouse’s death.
Continuing with the example above, assuming Ann and Dave own the home jointly with rights of survivorship, even though Ann becomes the sole owner automatically at Dave’s death, in a common-law state only Dave’s cost basis in the house would increase to $200,000 (a partial step-up). Ann’s basis would remain at $75,000 (half of the original $150,000 paid for the home). If Ann then sold the house for $400,000, she would earn a profit of $125,000 ($400,000 minus Ann’s basis of $75,000 and Dave’s new basis of $200,000). If she doesn’t qualify for the $250,000 home sale exclusion, she’d owe capital gains tax on the $125,000 gain. Assuming a long-term capital gains tax rate of 15%, she would owe $18,750 in capital gains taxes.
There’s an important difference in how the step-up works between joint tenants with rights of survivorship and tenants in common. If Ann and Dave owned an investment account worth $400,000 with a basis of $150,000 as tenants in common, when Dave died, his half of the account ($200,000) would pass through his will or revocable trust and would receive a full step-up. So whoever received that account would receive $200,000 worth of securities with a $200,000 basis. Ann’s remaining half would be worth $200,000 and have only her original $75,000 basis. If instead they owned the investment account as joint tenants with rights of survivorship, Ann would end up with a $400,000 account with a $275,000 basis spread proportionally across all the securities in the account – no individual security would have a basis equal to its FMV on Dave’s date of death.
Cost basis adjustments are part of the typical estate transfer process. They happen automatically when an individual owns eligible appreciated assets, holds them until death and leaves them to heirs. Once an owner passes away, the property undergoes an appraisal, after which the cost basis is reset to the current fair market value (FMV). The key is that the owner doesn’t gift the assets during their lifetime, which would lock in their cost basis.
There are a few ways to potentially maximize a step-up in basis.
If you make a gift to someone who subsequently dies and leaves you that same asset in their estate plan, you get a new basis equal to FMV upon that person’s death. This strategy is most frequently used between spouses in noncommunity property states when one spouse is very likely to die before the other but not too soon after the gift. Why? The IRS will deny the step-up in basis if the original recipient dies within a year of receiving the gift. So you can’t give a low-basis asset to someone and get it back with a stepped-up basis if that person dies within a year of receiving the gift.
Select common law states, including Alaska, South Dakota and Tennessee, allow couples to elect community property-like treatment through a community property trust. If properly established and administered, this kind of arrangement may allow all the couple’s assets to receive a full step-up in basis at the time of the first spouse’s death. It’s best to consult a financial or legal professional about this option, however, as it can be legally complex.
Whether you’re planning your estate or expecting an inheritance, you’ll need a solid understanding of how a step-up in basis works. Here’s the truth behind a few common misconceptions:
- Not all assets receive a step-up in basis: While many types of inherited property may qualify for a step-up in basis, certain assets don’t. These include retirement accounts, annuities, pensions, etc.
- Joint assets may receive only a partial step-up: In common law states, only the decedent’s share of jointly owned property typically receives a step-up in cost basis. The surviving spouse retains their original cost basis in their share. This may work differently depending on whether assets are owned as tenants in common or with rights of survivorship.
- Gifting assets can backfire: Carryover basis rules apply to gifts made during the original owner’s lifetime; in these cases, the recipient assumes the original owner’s cost basis. This is also true for gifts made to grantor trusts.
- Basis adjustments don’t only go up: Cost basis often increases at death, but it can also decrease if an asset has depreciated in value. Regardless of original cost, the basis of inherited assets is their value at the decedent’s date of death (or the alternate valuation date).
- Step-ups don’t eliminate all taxes: A step-up in basis often reduces the amount of capital gains tax due, but it doesn’t always eliminate taxes altogether. You’ll still need to run the numbers to determine how much you may owe.
- Deathbed transfers won’t always work: If you attempt a transfer to someone expecting them to give the assets back to you in their will so you get them back with a stepped-up basis, the asset won’t receive a step-up in basis if they die within a year of receiving the gift from you.
- You can guess wrong: Putting assets into one spouse’s name with the expectation that the named spouse will be the first to die can sometimes result in the named spouse unexpectedly living longer than the other, denying any step-up on the first spouse’s death.
The step-up in basis rule prevents the often impractical task of identifying and documenting the original cost basis of assets during estate transfers. More importantly, it can significantly reduce the capital gains tax heirs owe when selling inherited property. If you’re interested in the most efficient way to transfer wealth, either as a current owner or as a soon-to-be heir, understanding cost basis adjustments is essential. A J.P. Morgan advisor can offer personalized guidance by taking a closer look at your specific situation and helping you map out the next steps.
