Do Special Needs Trust Assets Get a Step-Up in Basis? (w/Examples) + FAQs

Quick Answer

It depends on the trust type. Assets in a first-party special needs trust usually get a step-up in basis when the disabled beneficiary dies, because those assets sit in the beneficiary’s taxable estate. Assets in a third-party trust usually do not, unless the trust is built to include them in someone’s estate.

A special needs trust (SNT) holds money for a person with a disability without wrecking their Medicaid or Supplemental Security Income (SSI). When the beneficiary dies, the family faces a sharp tax question that nobody warned them about: do the leftover stocks, mutual funds, or the family home reset to today’s value, or do the heirs inherit a hidden capital gains bill from decades ago? The wrong answer can cost a family tens of thousands of dollars.

The stakes are real and growing. The IRS made the rule stricter in 2023, and many trusts written before then were never designed with the basis question in mind. With the federal estate tax exemption now a permanent $15 million per person for 2026 under the One Big Beautiful Bill Act, almost no SNT family will owe estate tax — yet that same fact is exactly what can deny them a step-up and trigger a capital gains tax instead.

This article reflects federal rules and general state treatment as of June 2026 and covers tax year 2025 (for the 2026 filing season). Tax law changes — confirm current figures before you file. This is educational, not legal or tax advice for your specific situation; a complex trust calls for a tax attorney or CPA.

Here is what you will learn:

🧬 The single rule that decides every step-up question: was the asset in someone’s taxable estate at death?
⚖️ Why first-party and third-party SNTs split in opposite directions — and which one you have.
📜 What Revenue Ruling 2023-2 changed for grantor trusts, in plain English.
🧮 Worked dollar examples showing exactly how much capital gains tax a step-up saves — or costs.
🚫 Seven costly mistakes trustees and families make, and how to avoid each one.

The One Rule Behind Every Step-Up Question

A “step-up in basis” is a tax reset. Basis is what you paid for an asset; gain is the sale price minus that basis. When someone dies, Section 1014 of the Internal Revenue Code resets the basis of their assets to fair market value on the date of death. The heirs can then sell right away and owe little or no capital gains tax.

But here is the part most people miss. The step-up under Section 1014 is not automatic for anything held in trust. It applies only to property that is included in a decedent’s gross estate for federal estate tax purposes. That is the entire game. If the asset counts as part of someone’s taxable estate when they die, it gets the step-up. If it does not, it keeps its old, low basis — and the heirs inherit the built-in gain.

This single test cuts cleanly through every special needs trust question. You never ask “is this a grantor trust?” first. You ask: when the relevant person died, were these assets in that person’s taxable estate? The consequence of getting this wrong is concrete. A family that assumes a step-up, sells appreciated stock, and skips the gain on their return can face a 20% federal capital gains rate plus the 3.8% net investment income tax, an IRS notice, and penalties.

The common misconception is that “irrevocable trust” means “no step-up” and “revocable trust” means “step-up.” That is wrong. The label on the trust document does not control. Estate inclusion controls. Your next step is to figure out which type of SNT you have and whose death triggers the question, because that tells you whether the assets were ever in a taxable estate.

Which Situation Applies to You?

The answer changes completely based on three facts: the type of trust, whose money funded it, and whose death you are asking about. Find your row below, then read the matching section.

You have a first-party SNT and the disabled beneficiary just died. The assets are in the beneficiary’s estate, so a step-up generally applies. Read “First-Party Trusts” and “Medicaid Payback.”
You are a parent who set up a third-party SNT for your child. No step-up happens at your child’s death by default, because you, not the child, owned the assets. Read “Third-Party Trusts.”
You set up a third-party SNT and you (the grantor) just died. Whether the trust assets get a step-up depends on how the trust was drafted and whether the assets land in your estate. Read “Third-Party Trusts” and “Revenue Ruling 2023-2.”
You hold a revocable living trust that names a disabled person. The assets are still in your estate while you live, so they get a step-up at your death. Read “Revenue Ruling 2023-2.”

A first-party special needs trust (also called a self-settled, d4A, or payback trust) is funded with the disabled person’s own money — most often a personal injury settlement, an inheritance, or back-owed benefits. A third-party special needs trust is funded with someone else’s money, usually a parent’s or grandparent’s, and never belonged to the beneficiary. That funding source is the fork in the road for both Medicaid payback and the step-up.

First-Party SNTs: Step-Up Usually Applies

In a first-party SNT, the assets came from the disabled beneficiary and the law treats the beneficiary as the true owner. Because of that ownership, the trust assets are pulled into the beneficiary’s gross estate at death under Sections 2036 and 2038. Once they are in the estate, Section 1014 gives them a step-up to fair market value on the date of death.

The consequence is favorable for the people who inherit what is left. After the mandatory Medicaid payback, any remaining appreciated assets — stock, a mutual fund, real estate — carry a fresh, high basis. The remainder beneficiaries (often siblings) can sell with little or no capital gains tax. A first-party SNT funded with a $2 million malpractice settlement that grows over 25 years can leave heirs a meaningful step-up on the growth.

A real misconception here is that the Medicaid payback “cancels” the step-up. It does not. The payback is a debt paid in cash or asset value; the step-up is a separate income tax event on the assets themselves. Both happen. Your next step as a trustee is to get a date-of-death appraisal or brokerage valuation immediately, because that figure becomes the new basis and you will need it to report any later sale correctly.

Third-Party SNTs: Usually No Step-Up at the Beneficiary’s Death

A third-party SNT is the trust a parent or grandparent creates for a disabled child. The money never belonged to the child, so when the child (beneficiary) dies, nothing is included in the child’s estate — there is no step-up at the beneficiary’s death, and there is no Medicaid payback either. The leftover assets simply pass to the named remainder beneficiaries with whatever basis the trust already had.

The harder question is what happens at the grantor’s death — the parent who funded it. If the parent set up an irrevocable third-party SNT during life and gave away all control, those assets are usually excluded from the parent’s estate. Under current law that means no step-up, and the heirs inherit the parent’s old basis. The consequence is a potential capital gains tax on decades of growth that a step-up would have erased.

Here is the empowering part: drafting can change the answer. If the trust is built so the assets are included in the grantor’s estate — for example, by giving the grantor a retained power of appointment or other estate-inclusion power — the assets can still qualify for the step-up. Because the 2026 estate exemption is $15 million per person, including these assets almost never creates an estate tax bill, yet it unlocks the income tax step-up. Your next step is to have an estate attorney review whether your SNT has, or can add, an estate-inclusion provision.

Revenue Ruling 2023-2: What Actually Changed

In 2023 the IRS issued Revenue Ruling 2023-2, and it sent a shock through the trust world. The ruling confirmed that assets in an irrevocable grantor trust do not get a Section 1014 step-up when the grantor dies if those assets are excluded from the grantor’s gross estate. Being a “grantor trust” for income tax purposes — where the grantor pays the trust’s income tax — is not enough to earn a step-up.

This matters for third-party SNTs because many are drafted as irrevocable grantor trusts. Before the ruling, some advisors argued grantor-trust status alone might justify a basis reset. The IRS shut that argument down. The consequence is direct: if a parent’s SNT is an irrevocable grantor trust whose assets sit outside the parent’s estate, the heirs get no step-up, and the built-in gain survives the parent’s death.

The biggest misconception spawned by this ruling is that it killed the step-up for all irrevocable trusts and even living trusts. It did not. The ruling does not touch revocable living trusts or any irrevocable trust whose assets remain includible in the grantor’s estate. The rule is unchanged from decades of law — estate inclusion drives the step-up. Your next step is to ask your attorney one precise question: “Are this trust’s assets includible in the grantor’s gross estate?” The answer settles everything.

How the Estate Tax Exemption Fits In

Some families fear that pulling SNT assets into the grantor’s estate to capture a step-up will trigger estate tax. For 2026, that fear is almost always unfounded. The One Big Beautiful Bill Act set a permanent $15 million per-person exemption, or $30 million for a married couple, indexed for inflation.

That means a family with, say, a $1.2 million SNT and a $4 million total estate pays zero federal estate tax even with the trust included. They lose nothing on the estate side and gain a full income tax step-up. The consequence of not using estate inclusion in that situation is pure waste — paying capital gains tax that costs nothing to avoid. The next step is to confirm the grantor’s total estate is comfortably under $15 million and, if so, prioritize estate inclusion for the step-up.

Worked Examples: The Real Dollar Difference

Numbers make this concrete. Each example below uses a 2025 long-term capital gains rate of 20% for higher earners (the top federal rate), plus the 3.8% net investment income tax where it applies. State income tax is ignored for clarity; most states tax capital gains too.

Example 1 — First-party SNT, step-up applies. Maria, age 41, has a first-party SNT funded by a car-accident settlement. The trust holds stock bought for $100,000 that is worth $400,000 when Maria dies. Because the assets are in Maria’s estate, the basis steps up to $400,000. After the Medicaid payback, her sister sells the stock for $400,000 and owes $0 capital gains tax. Without a step-up, the $300,000 gain would have cost roughly $71,400 (23.8%).

Example 2 — Third-party SNT, no step-up at beneficiary’s death. James funds an irrevocable third-party SNT for his son David. It holds a rental property with a $150,000 basis, worth $500,000 when David dies. Nothing is in David’s estate, so there is no step-up. The remainder beneficiary inherits the $150,000 basis and, on a $500,000 sale, faces a $350,000 gain — about $83,300 in federal tax.

Example 3 — Third-party SNT redrafted for estate inclusion. Same facts as Example 2, but James’s attorney gives James a retained power that pulls the property into James’s estate. James’s total estate is $5 million, far under the $15 million exemption, so no estate tax is due. When James dies, the property basis steps up to $500,000. A later sale at $500,000 produces $0 capital gains tax — an $83,300 swing from drafting alone.

Three Common Scenarios at a Glance

These tables show how the same death produces different tax outcomes depending on the trust.

First-Party SNT — Beneficiary Dies	Tax Outcome
Assets included in beneficiary’s estate	Step-up to date-of-death value applies
Medicaid payback required first	Paid as a debt; does not block the step-up
Heirs sell appreciated assets after	Little or no capital gains tax owed

Third-Party SNT (Irrevocable, Excluded) — Grantor Dies	Tax Outcome
Assets excluded from grantor’s estate	No step-up under Rev. Rul. 2023-2
Heirs inherit grantor’s original basis	Built-in gain survives the death
Heirs sell appreciated assets	Capital gains tax on full appreciation

Third-Party SNT Drafted for Estate Inclusion — Grantor Dies	Tax Outcome
Assets included in grantor’s estate	Full step-up to date-of-death value
Estate under $15M exemption (2026)	No federal estate tax triggered
Heirs sell appreciated assets	Little or no capital gains tax owed

Key Players and How They Connect

Several entities decide the outcome, and each has a defined role. Understanding who does what prevents costly assumptions.

The grantor (settlor). The person who creates and funds the trust. In a third-party SNT, this is usually the parent, and the grantor’s estate inclusion controls the step-up.
The beneficiary. The person with a disability. In a first-party SNT the beneficiary is also the source of the funds, which is why their estate gets the step-up.
The trustee. Administers the trust, files Form 1041 for trust income, obtains the date-of-death valuation, and handles distributions.
The IRS. Applies Section 1014 and Revenue Ruling 2023-2, and audits returns that claim a step-up the trust does not qualify for.
The state Medicaid agency. Holds a payback claim against a first-party SNT, satisfied before remainder beneficiaries receive anything.

The chain works like this: the grantor’s choices at drafting set whether assets land in an estate; estate inclusion triggers the step-up; the trustee documents the new basis; and the IRS later checks the math when assets are sold. A break anywhere in that chain costs the family money.

Federal vs. State Treatment

Federal law sets the step-up rule under Section 1014, and that is the rule covered above. States, however, run their own income tax systems, and they do not always mirror federal basis treatment for capital gains.

Most states with an income tax start from the federal basis figure, so an asset that gets a federal step-up generally gets the same stepped-up basis for state capital gains too. A handful of states have no income tax at all — including Florida, Texas, and Washington’s wage income — so capital gains on inherited SNT assets face no state-level tax there, step-up or not. The consequence is that the federal analysis is the main event, but a family in a high-tax state like California faces a larger absolute tax bill when no step-up applies. Your next step is to confirm your state’s conformity with federal basis rules before assuming a sale is tax-free; for most filers, the IRS Form 8949 guide and Schedule D control the reporting on the federal side.

Mistakes to Avoid

Each of these errors carries a real cost. Watch for them as a trustee, parent, or heir.

Assuming “irrevocable” means no step-up. You may skip a step-up you actually qualify for, overpaying capital gains tax by thousands. Estate inclusion, not the label, controls.
Assuming “grantor trust” guarantees a step-up. After Revenue Ruling 2023-2, a grantor trust excluded from the estate gets no step-up; claiming one invites an IRS adjustment and penalties.
Failing to get a date-of-death valuation. Without an appraisal or brokerage statement, you cannot prove the new basis, and the IRS may default to the old, lower one.
Confusing the two trust types. Treating a third-party trust like a first-party trust can lead you to wrongly expect both a payback and a step-up — or neither.
Drafting a third-party SNT with no estate-inclusion power. When the grantor’s estate is far under $15 million, this throws away a free step-up and burdens heirs with built-in gain.
Forgetting state capital gains tax. Assuming a federal step-up wipes out all tax ignores state income tax, which can add several percentage points in high-tax states.
Selling assets before confirming basis. A trustee who sells first and asks later may report the wrong gain, triggering an amended return or audit.

Do’s and Don’ts

Do identify your trust type first — first-party or third-party — because it drives every answer. Why: the funding source determines whose estate the assets sit in.
Do obtain a written date-of-death valuation for every asset. Why: it sets and proves the new basis for any future sale.
Do ask your attorney whether SNT assets are includible in the grantor’s estate. Why: that single answer decides the step-up.
Do check your state’s income tax treatment of inherited assets. Why: federal step-up does not always control the state bill.
Do review third-party SNTs drafted before 2023. Why: Revenue Ruling 2023-2 may have changed the outcome you were counting on.
Don’t rely on the trust’s title to predict the step-up. Why: “irrevocable” and “grantor” labels mislead more than they help.
Don’t ignore the Medicaid payback in a first-party trust. Why: it must be satisfied before heirs receive anything, though it does not block the step-up.
Don’t add estate-inclusion powers without checking the grantor’s total estate. Why: in the rare $15 million-plus estate it could create estate tax.
Don’t sell appreciated assets before confirming the correct basis. Why: a wrong gain figure can mean penalties.
Don’t treat this as a do-it-yourself project for a large trust. Why: the dollar swings justify professional review.

Pros and Cons of Pursuing a Step-Up via Estate Inclusion

Pro: Eliminates built-in capital gains. Heirs can sell appreciated assets with little or no income tax. Why: the basis resets to date-of-death value.
Pro: Usually free under the 2026 exemption. A $15 million per-person shield means most families owe no estate tax for including assets. Why: the estate stays under the threshold.
Pro: Simplifies heirs’ future sales. A high, documented basis makes reporting a later sale clean. Why: gain is small and easy to calculate.
Pro: Flexible drafting. Estate-inclusion powers can often be added or designed at the start. Why: attorneys have several tools, such as retained powers of appointment.
Pro: Protects the family’s net benefit. More money reaches the people the grantor intended. Why: tax savings stay in the family.
Con: Requires careful drafting. A poorly worded power can fail or cause unintended results. Why: estate inclusion rules are technical.
Con: Risk for very large estates. Families over $15 million could face estate tax on the included assets. Why: inclusion adds to the taxable estate.
Con: May reduce some asset protection. Retained powers can expose assets to the grantor’s creditors. Why: control and protection often trade off.
Con: Ongoing complexity. Grantor trusts add tax-filing and tracking duties. Why: the grantor reports trust income during life.
Con: Needs periodic review. Law changes, like Revenue Ruling 2023-2, can shift the analysis. Why: what worked at drafting may not hold later.

What to Do Next

Take these steps in order. They move you from confusion to a documented, defensible tax position.

Identify the trust type and funding source. Pull the trust document and confirm whether it is first-party or third-party. This determines whose estate matters.
Determine whose death is at issue — the beneficiary’s or the grantor’s — because the step-up answer differs for each.
Get a date-of-death valuation of every trust asset right away. Use a licensed appraiser for real estate and brokerage statements for securities.
Ask an estate attorney the inclusion question. Confirm in writing whether the assets are includible in the relevant person’s gross estate.
Satisfy any Medicaid payback in a first-party trust before distributing to remainder beneficiaries; contact the state Medicaid agency for the exact figure.
Report correctly. Have the trustee or heirs use the Form 8949 and Schedule D guide for any sale, and the trust files Form 1041 for its income.
Call a professional when the trust is large or the answer is unclear. A tax attorney or CPA review typically runs a few hundred to a few thousand dollars — far less than a mistaken capital gains bill. For related planning, see the trust income tax basics and an estate-tax-exemption guide in this cluster.

FAQs

Do special needs trust assets get a step-up in basis?

Sometimes. First-party SNT assets usually get a step-up at the beneficiary’s death because they are in the beneficiary’s estate. Third-party SNT assets usually do not, unless the trust is drafted to include them in the grantor’s estate.

Does a first-party special needs trust get a step-up in basis?

Yes. Because a first-party SNT holds the disabled beneficiary’s own money, the assets are included in the beneficiary’s gross estate at death, qualifying them for a Section 1014 step-up to date-of-death value for 2025 and beyond.

Does a third-party special needs trust get a step-up at the beneficiary’s death?

No. The beneficiary never owned the assets, so nothing is in the beneficiary’s estate. The remainder beneficiaries inherit the trust’s existing basis, and there is no Medicaid payback either.

What did Revenue Ruling 2023-2 change?

It confirmed no step-up for excluded grantor-trust assets. Effective in 2023, irrevocable grantor trust assets that are excluded from the grantor’s estate do not receive a Section 1014 step-up, even though the grantor pays the trust’s income tax.

Does the Medicaid payback cancel the step-up?

No. The payback is a debt satisfied from the trust, while the step-up is a separate income tax event on the assets. In a first-party SNT, both occur; the payback simply happens before heirs receive what remains.

Can a third-party SNT be drafted to get a step-up?

Yes. By including estate-inclusion powers, such as a retained power of appointment, the grantor can pull the assets into their estate. With the 2026 exemption at $15 million, this usually triggers no estate tax but unlocks the step-up.

Does grantor trust status alone create a step-up?

No. Revenue Ruling 2023-2 makes clear that paying a trust’s income tax as the grantor does not, by itself, earn a step-up. The assets must be includible in the grantor’s gross estate.

Will including SNT assets in an estate cause estate tax?

Almost never for 2026. The permanent OBBBA exemption is $15 million per person, or $30 million per couple. Most SNT families fall far below this, so estate inclusion costs nothing while securing the step-up.

Do revocable living trusts get a step-up?

Yes. A revocable living trust’s assets remain in the grantor’s estate during life, so they receive a full step-up at the grantor’s death. Revenue Ruling 2023-2 does not change this result.

What form reports a sale of stepped-up trust assets?

Form 8949 and Schedule D. The seller reports the sale on these federal forms, using the stepped-up date-of-death value as basis. The trust itself reports income on Form 1041 during administration.

Do states follow the federal step-up rule?

Most do. States with an income tax generally start from federal basis, so a federal step-up carries to state capital gains. No-income-tax states like Florida and Texas do not tax the gain at all.

When should I hire a professional for an SNT basis question?

When the trust holds significant appreciated assets. If a step-up could swing thousands of dollars, or the trust predates 2023, a tax attorney or CPA review protects the family from a costly reporting error.

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