Can Trusts Benefit From Step-Up in Basis Rules? (w/Examples) + FAQs

Yes, some trusts can secure the valuable step-up in basis tax break for your heirs, but the type of trust you choose is critical. A revocable trust, which you control, almost always qualifies. Many irrevocable trusts, which you cannot easily change, will forfeit this benefit.

The primary conflict arises from a direct collision between your goals and the tax code. Internal Revenue Code (IRC) § 1014 states that an asset’s value can only be “stepped up” to its market value at your death if it is included in your taxable estate. The problem is that many irrevocable trusts are specifically designed to remove assets from your estate, which disqualifies them from the step-up, a position the IRS solidified in Revenue Ruling 2023-2.¹ This is a high-stakes issue, as the Congressional Budget Office estimated that over one-fifth of the benefit from this rule goes to the top one percent of earners.³

Here is what you will learn:

• The Billion-Dollar Tax Eraser 💵: Understand what step-up in basis truly means and how this single rule can legally erase decades of taxable gains on your home, stocks, or business.
• The Two Trusts Tale ⚖️: Discover why a revocable (“living”) trust is usually your best friend for getting a step-up, while a standard irrevocable trust can become a tax trap for your heirs.
• The IRS’s Game-Changing Ruling 📜: Learn about Revenue Ruling 2023-2 and why it slammed the door on a popular strategy, forcing a major rethink of many existing estate plans.
• Clever Ways to Still Get the Step-Up 💡: Explore advanced legal strategies that planners use to design special irrevocable trusts that can still secure this valuable tax benefit for your family.
• The “Magic” of Community Property ✨: See how living in one of nine specific states can give your surviving spouse a massive tax advantage—the “double step-up”—that isn’t available elsewhere.

The Billion-Dollar Tax Eraser: What “Step-Up in Basis” Really Means

To grasp how trusts affect your taxes, you first need to understand the concept of “basis.” An asset’s basis is its starting point for measuring profit when you sell it. For most things you buy, like a house or shares of stock, the basis is simply the purchase price.⁴

When you sell that asset, you owe capital gains tax on the difference between the sale price and your basis.⁴ The step-up in basis is a powerful tax rule that changes this calculation for assets your heirs inherit. Under IRC § 1014, the basis of an inherited asset is reset—or “stepped up”—to its fair market value on the date you die.⁵

This means all the appreciation that occurred during your lifetime is permanently erased for income tax purposes.⁷ For example, imagine you bought stock for $10,000 and it’s worth $250,000 when you die. Your child inherits it with a new, stepped-up basis of $250,000, and if they sell it immediately, they owe zero capital gains tax.⁸

It is critical to know that this benefit only applies to assets transferred at death. If you gift an asset during your life, the recipient gets your original carryover basis.⁷ This distinction makes holding onto highly appreciated assets until death a cornerstone of modern estate planning.⁴

The Great Divide: Why Revocable and Irrevocable Trusts Are Taxed Differently

A trust is a legal tool that holds your assets, managed by a trustee for your beneficiaries. The two main types, revocable and irrevocable, are treated in opposite ways for tax purposes. This difference comes down to one simple factor: control.

Revocable Trusts: Your Ticket to a Guaranteed Step-Up

A revocable trust, often called a “living trust,” is one you can change or cancel at any time.⁹ Because you keep complete control, the IRS considers the assets inside it to still be part of your taxable estate.¹⁰ This is the key to unlocking the tax break.

Since the assets are included in your estate, they automatically qualify for the step-up in basis under IRC § 1014.¹¹ This allows your heirs to inherit your property, avoid the public court process of probate, and eliminate capital gains taxes all at once. It’s the most straightforward way to achieve all three goals.

Your Action	The Tax Consequence
1. Create & Fund the Trust: You buy a home for $200,000 and transfer it into your revocable trust. You remain in full control as the trustee.	The home is now owned by the trust, which means it will avoid probate court.4 For tax purposes, nothing changes; you are still treated as the owner.
2. You Pass Away: You die 30 years later when the home is worth $1 million. Your daughter becomes the successor trustee.	The home is included in your taxable estate. Its basis is “stepped up” from your original $200,000 to the current fair market value of $1 million.12
3. Your Heir Sells the Home: Your daughter sells the home three months later for $1.02 million to settle your affairs.	Her taxable capital gain is only $20,000 ($1.02M Sale Price – $1M Stepped-Up Basis). The $800,000 of appreciation during your life is never taxed.13

The Irrevocable Trust Trap: When Asset Protection Kills a Tax Break

An irrevocable trust is one you generally cannot change or cancel after you create it.¹⁰ People use these trusts to protect assets from creditors or to reduce their estate for estate tax purposes.¹⁵ To get these benefits, you must give up control and ownership of the assets.

This act of giving up control is precisely what creates the tax problem. By successfully removing the assets from your taxable estate, they no longer qualify as “property acquired from a decedent” under IRC § 1014.¹⁴ As a result, the trust and its beneficiaries are stuck with your original carryover basis, potentially creating a huge future tax bill.¹⁷

The Tax Man Cometh: How IRS Revenue Ruling 2023-2 Changed Everything

For years, some estate planners used a strategy involving a special “grantor trust” to try to get the best of both worlds. The assets were outside the estate for estate tax purposes but were treated as owned by the grantor for income tax purposes.¹ The argument was that this income tax link should be enough to qualify for a step-up.

In March 2023, the IRS slammed this door shut. Revenue Ruling 2023-2 definitively stated that if an asset is not included in a decedent’s gross estate, it does not receive a step-up in basis.¹ The IRS made it clear that an asset’s status for income tax purposes is irrelevant; only inclusion in the taxable estate matters for basis.¹⁸

This ruling forces a choice: you can have asset protection and estate tax savings, or you can have the step-up in basis. You cannot have both with a standard irrevocable trust.

Your Action	The Tax Consequence
1. Create & Fund the Trust: You transfer a stock portfolio with a basis of $100,000 into a standard irrevocable trust to protect it from creditors. It is now outside your taxable estate.	The trust’s basis in the stock is your carryover basis of $100,000. You have permanently given up control of these assets.
2. You Pass Away: You die when the portfolio is worth $1.5 million.	Because the portfolio is not in your gross estate, Revenue Ruling 2023-2 confirms there is no step-up in basis. The basis remains $100,000.2
3. Your Heirs Sell the Stock: The trustee distributes the stock to your children, who sell it for $1.5 million.	Their taxable capital gain is $1.4 million ($1.5M Sale Price – $100k Basis). At a combined 25% tax rate, they face a tax bill of $350,000—a tax that a revocable trust would have completely avoided.

Outsmarting the Tax Code: 3 Legal Ways to Secure a Step-Up in an Irrevocable Trust

It is still possible to get a step-up with an irrevocable trust, but it requires intentional planning. With the federal estate tax exemption at a historic high ($13.61 million in 2024), most families are more concerned with avoiding capital gains tax than estate tax.¹² These strategies deliberately cause estate inclusion to capture the more valuable tax break.

Strategy 1: The “General Power of Appointment” Switch

A “power of appointment” is a right given to a person in a trust to direct where the assets go. A General Power of Appointment (GPA) gives someone (like your spouse or child) the unrestricted right to give the trust assets to anyone, including themselves or their own estate.¹⁹

Because this power is so absolute, IRC § 2041 forces the trust assets to be included in the powerholder’s taxable estate when they die. This estate inclusion is the trigger that qualifies the assets for a brand new step-up in basis at the powerholder’s death.¹⁹ This is a common way to get a second step-up for the next generation.

Strategy 2: The Last-Minute “Swap Power” Maneuver

Many modern irrevocable trusts contain a “power of substitution,” or swap power, authorized under IRC § 675(4)(c).²⁰ This gives the grantor the right to exchange personal assets for trust assets of equal value. It’s a powerful tool for last-minute basis planning.

The strategy is to wait until near the end of life, then swap high-basis assets (like cash) into the trust in exchange for low-basis, appreciated assets (like stock) out of the trust.¹ This exchange is not a taxable sale.²² The low-basis assets are now back in your personal estate and will receive a full step-up at your death, while the trust is left holding cash that didn’t need a step-up.⁶

Strategy 3: Modernizing Old Trusts Through “Decanting”

Many older irrevocable trusts were designed to avoid estate taxes and lack modern flexibility. Depending on state law, it may be possible to modify these trusts through a court order or a process called “decanting”.¹⁶ Decanting allows a trustee to “pour” the assets from an old, inefficient trust into a new one with better terms.

A common goal of decanting is to add a General Power of Appointment to an old trust. This creates the opportunity for a future step-up in basis that the original trust document did not permit.¹⁶

The Geographic Jackpot: How Living in a Community Property State Supercharges Your Step-Up

Your state’s marital property laws can dramatically change the tax outcome for your surviving spouse. The U.S. has two systems: common law (41 states) and community property. The nine community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.⁴

In community property states, most assets acquired during a marriage are owned 50/50. This leads to a huge tax advantage called the “double step-up.” Under IRC § 1014(b)(6), when the first spouse dies, both halves of the community property get a full step-up in basis to the current market value.⁴

In a common law state, only the deceased spouse’s half of a jointly owned asset gets a step-up.²¹ The surviving spouse’s half keeps its original low basis, which can lead to a massive tax bill.

Location of Couple	The Tax Consequence of Selling a $1.2M Property
California (Community Property State)	A couple bought a property for $200,000. When one spouse dies, the entire basis is stepped up to its current $1.2 million value. The surviving spouse can sell it for $1.2 million and owe $0 in capital gains tax.22
New Jersey (Common Law State)	Only the deceased spouse’s 50% interest gets a step-up. The new basis is $700,000 ($100k original basis for the survivor’s half + $600k stepped-up basis for the decedent’s half). A sale at $1.2 million creates a $500,000 taxable gain.25

Weighing Your Options: The Pros and Cons of Different Trust Strategies

Choosing the right trust involves balancing competing goals. What you gain in asset protection you might lose in tax benefits. Understanding these trade-offs is essential for making an informed decision.

Feature	Revocable Trust	Irrevocable Trust (Standard)
Step-Up in Basis	Pro: Assets are included in your estate and receive a full step-up in basis, saving your heirs from capital gains tax.	Con: Assets are removed from your estate and do not receive a step-up, creating a potential tax liability for heirs.
Asset Protection	Con: Because you retain control, assets are not protected from your creditors or lawsuits.	Pro: Assets are owned by the trust and are generally protected from your future creditors and legal judgments.
Estate Tax Savings	Con: Assets remain in your taxable estate and offer no protection from federal or state estate taxes.	Pro: Removes assets and their future growth from your taxable estate, which can save significant money for very large estates.
Control & Flexibility	Pro: You can change, amend, or terminate the trust at any time, giving you complete flexibility.	Con: You permanently give up control and cannot easily change the terms or get the assets back.
Probate Avoidance	Pro: Assets held in the trust pass directly to your beneficiaries, avoiding the time and expense of probate court.	Pro: Like a revocable trust, assets pass outside of probate, ensuring a private and efficient transfer to beneficiaries.

Tax Traps and Tripwires: 4 Common Mistakes That Forfeit Your Step-Up

Simple errors can accidentally cost your family hundreds of thousands of dollars in taxes. Avoiding these common pitfalls is just as important as choosing the right trust.

• Mistake 1: Adding a Child to Your Deed. Putting your child’s name on your house as a joint owner is a gift of a partial interest. At your death, only your portion of the property gets a step-up. Your child’s portion is stuck with the low original basis, creating a huge potential tax bill when the house is sold.²⁷
• Mistake 2: Making Deathbed Gifts. Gifting a highly appreciated asset right before you die is a terrible tax move. The gift locks in the low carryover basis. If you had held the asset until death, your heir would have received a full step-up, wiping out all the taxable gain.²⁷
• Mistake 3: Failing to Fund Your Trust. A trust is an empty legal shell until you formally transfer assets into it. If you create a trust but never sign a new deed for your house or retitle your brokerage account, those assets will still have to go through probate, defeating a primary purpose of the trust.⁴
• Mistake 4: Ignoring the “Step-Down” in Basis. The basis rule works both ways. If an asset has lost value, its basis is “stepped down” to the lower market value at death. This permanently erases the capital loss. It is often better to sell a depreciated asset before death to realize the loss on your own tax return.²⁹

Frequently Asked Questions (FAQs)

1. If I inherit stock from a trust and sell it right away, do I owe tax?No, not usually. If the trust allowed for a step-up, your basis is the value at death. A sale for that same price results in zero taxable gain, aside from any minor market fluctuations.30
2. Does a revocable trust avoid estate taxes?No. Because you retain control, the assets in a revocable trust are still part of your estate for estate tax purposes. It is a tool for avoiding probate, not estate taxes.
3. Did the 2023 IRS ruling get rid of the step-up for all irrevocable trusts?No. It only confirmed that assets do not get a step-up if they are excluded from the taxable estate. Trusts can be designed to ensure estate inclusion and still get the step-up.1
4. How do I figure out the “fair market value” of a house I inherited?You must get a formal appraisal from a certified appraiser effective as of the date of death. The property tax assessment value is not sufficient for the IRS.31
5. Does the step-up apply to my 401(k) or IRA?No. Retirement accounts are considered “Income in Respect of a Decedent” and do not receive a step-up. Your beneficiaries will owe ordinary income tax on withdrawals, just as you would have.32
6. My spouse and I live in Florida. Can we get the “double step-up”?No, not automatically, as Florida is a common law state. However, some common law states allow for special “community property trusts” that may let you qualify for the full step-up.6
7. What happens to depreciation on an inherited rental property?It gets wiped out. The step-up in basis to fair market value eliminates any potential “depreciation recapture” tax that would have been due if the original owner had sold the property.22