The most effective estate strategy to optimize the step-up in basis is to hold onto your appreciated assets, such as real estate, stocks, and business interests, until you pass away. Transferring these assets through a will or a revocable trust allows your heirs to inherit them at their current market value, legally erasing a lifetime of built-up capital gains.
The primary conflict families face is rooted in Internal Revenue Code § 1014. This federal law grants the valuable “step-up in basis” to inherited assets but directly clashes with the “carryover basis” rule for assets given away during your lifetime. A well-intentioned gift of a highly appreciated family home can inadvertently transfer a massive, hidden tax liability to your loved ones, potentially forcing them to sell the asset just to pay the taxes.
This single rule is a major driver of wealth preservation, yet it is widely misunderstood. The Congressional Budget Office has estimated that this provision results in over $50 billion in forgone federal tax revenue each year, with over half of that benefit going to the top 5% of households by income. Proper planning is the only way to ensure your family benefits from it.
Here is what you will learn:
- ✅ How to legally erase decades of taxable gains on your property and investments.
- 🏠 The single biggest mistake homeowners make that costs their children thousands in taxes.
- 💔 How to protect your children’s inheritance in a blended family or second marriage.
- TRUST The difference between a revocable and irrevocable trust and a recent IRS ruling that changed everything.
- 🗺️ A state-by-state rule that gives some married couples a “double” tax benefit that others don’t get.
The Foundation: How a Simple Rule Creates (or Destroys) Generational Wealth
What Are “Basis” and “Capital Gains,” and Why Do They Matter?
Think of an asset’s tax basis as its original cost for tax purposes. If you buy a stock for $100, your basis is $100. If you buy a house for $200,000, your basis is $200,000. This number is the starting point for calculating profit.
A capital gain is the profit you make when you sell something for more than its basis. If you sell that $100 stock for $150, you have a $50 capital gain. If you sell that $200,000 house for $500,000, you have a $300,000 capital gain.
The government taxes these gains. The tax rate depends on how long you owned the asset.
- Short-Term Capital Gains: If you hold an asset for one year or less, the profit is taxed at your regular income tax rate, which can be quite high.
- Long-Term Capital Gains: If you hold an asset for more than one year, the profit is taxed at special, lower rates (0%, 15%, or 20% for most people).
The Million-Dollar Difference: Step-Up in Basis vs. Carryover Basis
The entire strategy of timing revolves around two conflicting rules from the Internal Revenue Service (IRS). One applies to gifts you give while you’re alive, and the other applies to assets your heirs inherit after you die. The difference can mean saving hundreds of thousands of dollars in taxes.
IRC § 1014: The “Step-Up in Basis” for Inheritances When your heirs inherit an asset from you, Internal Revenue Code § 1014 says the asset’s basis is “stepped up” to its fair market value (FMV) on the date of your death. This means all the capital gains that built up during your lifetime are completely erased for tax purposes. Your heir inherits it as if they bought it that day for its full price.
| Action | Consequence |
| Inheritance at Death | The asset’s tax basis is “stepped up” to its market value on the date of death. |
| Heir Sells Immediately | The sale price is equal to the new basis, resulting in $0 taxable gain. |
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The “Carryover Basis” Rule for Lifetime Gifts In stark contrast, when you gift an asset during your lifetime, the recipient gets your original basis. This is called a carryover basis because your low basis “carries over” to them. You are not just giving them an asset; you are also giving them your built-in tax bill.
| Action | Consequence |
| Lifetime Gift | The recipient inherits the giver’s original, low tax basis. |
| Recipient Sells Later | They must pay capital gains tax on all the appreciation, from the original purchase date to the sale date. |
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Strategic Decisions: Which Assets to Hold, Gift, or Sell
The Golden Rule of Step-Up Planning: Identifying the Right Assets
The step-up in basis rule applies to most capital assets that you own in your name or in a revocable trust. Knowing which assets qualify is the first step in building a tax-efficient estate plan.
Assets That Typically Qualify for a Step-Up:
- Real Estate: Your primary home, vacation properties, and rental properties.
- Taxable Investment Accounts: Stocks, bonds, and mutual funds held in brokerage accounts.
- Business Interests: Shares in a family business or an LLC.
- Valuable Personal Property: Art, antiques, and collectibles.
Assets That DO NOT Qualify for a Step-Up: A major planning mistake is assuming everything gets a step-up. Certain assets are specifically excluded, and distributions from them are taxed as ordinary income to your heirs.
- Retirement Accounts: Traditional IRAs, 401(k)s, 403(b)s, and pensions.
- Annuities: Tax-deferred annuities are also excluded.
- Cash: Bank accounts and certificates of deposit do not appreciate, so there is no gain to step up.
The Strategic Framework: A Simple Guide for Your Assets
This creates a clear hierarchy for how to manage your assets for maximum tax efficiency. The goal is to pass on low-basis assets at death and transfer high-basis assets during life.
- Hold Assets with Large Gains: Any asset that has significantly increased in value since you bought it is a prime candidate to hold until death. This allows your heirs to receive the full step-up and sell it with little to no tax.
- Gift Assets with Small Gains: If you want to give gifts, choose assets that have not appreciated much. Gifting cash or assets with a basis close to their current market value is tax-smart because you aren’t passing on a large embedded tax liability.
- Sell Assets with Losses: If you own an asset that is worth less than what you paid for it, you should consider selling it yourself. This allows you to claim a capital loss on your tax return, which can offset other gains. If you hold it until death, the basis “steps down,” and the tax loss is lost forever.
This framework has a profound impact on retirement planning. For retirees who want to leave a legacy, it is often more tax-efficient to spend money from their IRAs and 401(k)s first. Since those accounts don’t get a step-up anyway, spending them down preserves the highly appreciated stocks and real estate that will get a step-up for your heirs.
Real-World Scenarios: How Step-Up in Basis Plays Out
Scenario 1: The Family Home
This is the most common situation where families either save a fortune or make a costly mistake. Let’s look at a person named Sarah and her father, Tom.
Tom bought his home in 1985 for $100,000. Today, it is worth $500,000. Tom wants to give the house to Sarah.
| Tom’s Choice | Sarah’s Consequence |
| Option A: Gift the House Today | Sarah receives the house with Tom’s original $100,000 basis. If she sells it for $500,000, she has a $400,000 taxable gain. |
| Option B: Leave the House in His Will | Sarah inherits the house after Tom’s death. Her basis is “stepped up” to $500,000. If she sells it for $500,000, her taxable gain is $0. |
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By choosing to leave the house in his will, Tom saves Sarah from a massive tax bill. This simple act of timing is one of the most powerful wealth-transfer tools available.
Scenario 2: The Married Couple and the “Geography Lottery”
For married couples, where you live determines whether you get a good tax break or a great one. U.S. states follow one of two systems for marital property: common law or community property. This distinction has a huge impact on the step-up in basis for the surviving spouse.
The nine community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. All other states are common law states.
| State Law System | Impact on Surviving Spouse’s Basis |
| Common Law State | Only the deceased spouse’s 50% share of a jointly owned asset gets a step-up. The survivor’s 50% share keeps its original basis, creating a “blended” basis. |
| Community Property State | Both halves of the community property asset get a full “double step-up” to the market value at the first spouse’s death. The survivor can sell the entire asset tax-free. |
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Imagine a couple, Mark and Lisa, who bought stock together for $200,000. When Mark dies, the stock is worth $1 million.
| Mark and Lisa’s Situation | Lisa’s New Basis and Tax Outcome |
| Living in Florida (Common Law) | Lisa’s new basis is $600,000. ($100,000 from her half + $500,000 from Mark’s stepped-up half). If she sells for $1M, she has a $400,000 taxable gain. |
| Living in Texas (Community Property) | Lisa’s new basis is $1,000,000. Both halves step up. If she sells for $1M, she has $0 taxable gain. |
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This “geography lottery” can save the surviving spouse hundreds of thousands of dollars. Some common law states, like Alaska and Tennessee, now allow couples to create special “community property trusts” to get the same double step-up benefit.
Scenario 3: The Inherited Stock Portfolio
An inheritance often includes a brokerage account with stocks held for many years. The step-up in basis is crucial here, and it also comes with a hidden benefit.
Let’s say a nephew, Ben, inherits a stock portfolio from his aunt. The stocks were bought for $50,000 but are worth $300,000 on the date of her death.
| Action | Consequence |
| Inheritance | Ben’s basis in the portfolio is stepped up to $300,000. |
| Ben Sells One Month Later for $305,000 | His taxable gain is only $5,000. He also automatically gets long-term capital gains treatment, meaning he pays the lower tax rate even though he only held it for a month. |
This automatic long-term treatment is a powerful secondary benefit. It gives heirs the flexibility to sell assets immediately to cover estate expenses without being punished by high short-term tax rates.
Advanced Strategies: Using Trusts to Master Timing
Trusts are legal tools that hold assets on behalf of beneficiaries. They are essential for avoiding probate court, but they also have a complex relationship with the step-up in basis rule.
Revocable Living Trusts: The Best of Both Worlds
A revocable living trust is a trust you create and control during your lifetime. You can change it or cancel it at any time. For tax purposes, the IRS treats the assets in your revocable trust as if you still own them personally.
This means assets held in a revocable trust get a full step-up in basis at your death. This strategy is incredibly popular because it combines the probate-avoidance benefit of a trust with the tax-saving benefit of a step-up in basis.
Irrevocable Trusts: A Recent IRS Ruling Changes the Game
An irrevocable trust is one that generally cannot be changed or canceled after you create it. These are often used for asset protection or to reduce estate taxes. For years, there was confusion about whether assets in these trusts received a step-up.
In 2023, the IRS issued Revenue Ruling 2023-2, which settled the debate. The ruling states that for an asset to get a step-up, it must be included in the decedent’s gross estate for federal estate tax purposes.
Since most irrevocable trusts are specifically designed to remove assets from the estate, this ruling confirms that assets held in them will not receive a step-up in basis. This is a critical detail that makes many older, unreviewed estate plans potentially tax-inefficient for heirs.
Sophisticated Trust Techniques for High-Net-Worth Families
Even with the new ruling, advanced strategies exist to optimize the step-up.
- Power of Substitution: Some irrevocable trusts, called Intentionally Defective Grantor Trusts (IDGTs), contain a “swap power.” This allows the grantor to exchange assets of equal value with the trust. Shortly before death, the grantor can swap low-basis, appreciated assets out of the trust in exchange for high-basis assets like cash. This brings the appreciated assets back into their personal estate, making them eligible for a step-up.
- Bypass vs. Marital Trusts: For married couples, a key decision is how to structure trusts at the first spouse’s death.
- A Bypass Trust uses the first spouse’s estate tax exemption and is excluded from the surviving spouse’s estate. Assets in it do not get a second step-up when the survivor dies.
- A Marital Trust (or QTIP Trust) qualifies for the marital deduction and is included in the surviving spouse’s estate. Assets in it do get a second step-up at the survivor’s death.
With today’s high estate tax exemptions, many planners now favor using marital trusts to ensure assets get a second step-up, as avoiding capital gains tax is a more common concern than avoiding estate tax.
Mistakes to Avoid: Common and Costly Planning Failures
Many families miss out on the benefits of the step-up in basis due to simple, avoidable errors.
- Gifting Appreciated Property: This is the most common mistake. Giving away a low-basis asset during your lifetime permanently forfeits the step-up and saddles your loved one with a future tax bill.
- Adding a Child to the Deed: Putting your child’s name on the deed to your house as a joint tenant seems like an easy way to avoid probate. However, this is legally considered a gift of half the property, meaning that half loses its eligibility for a step-up in basis. It also exposes your home to your child’s potential creditors or divorce proceedings.
- Failing to Get an Appraisal: For assets like real estate or a family business, you must document the fair market value at the date of death. Failing to get a professional appraisal at that time can lead to major disputes with the IRS years later when the heir sells the property.
- Ignoring State Property Laws: The difference between common law and community property states can change the tax outcome for a surviving spouse by hundreds of thousands of dollars. A plan must be tailored to your state’s laws.
- Making “Deathbed Gifts”: The tax code has a special anti-abuse rule under IRC § 1014(e). If you gift an appreciated asset to someone who dies within one year, and you inherit that same asset back, you do not get a step-up in basis. This prevents people from manufacturing a tax break by giving assets to a terminally ill relative.
Do’s and Don’ts for Step-Up in Basis Planning
| Do’s | Don’ts |
| ✅ Hold highly appreciated assets until death. | ❌ Don’t gift low-basis assets like stocks or real estate. |
| ✅ Use a revocable living trust to hold assets. | ❌ Don’t add your children’s names to your property deeds. |
| ✅ Get a professional appraisal for real estate and businesses at the date of death. | ❌ Don’t assume all assets get a step-up (retirement accounts are excluded). |
| ✅ Review your estate plan regularly, especially if you move states. | ❌ Don’t forget to update beneficiary designations on all accounts. |
| ✅ Sell assets that have lost value during your lifetime to claim the tax loss. | ❌ Don’t try to create a step-up with a “deathbed gift.” |
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Pros and Cons of Relying on Step-Up in Basis
| Pros | Cons |
| Massive Tax Savings: It can completely eliminate capital gains tax on a lifetime of appreciation, preserving more wealth for your heirs. | Requires Holding Assets: It creates a “lock-in” effect, discouraging you from selling assets you might otherwise want to, which can lead to a poorly diversified portfolio. |
| Simplifies Record-Keeping: Heirs don’t need to track down decades-old purchase records to figure out the original basis. | Risk of “Step-Down”: If an asset has lost value, its basis will “step down” at death, and the capital loss is permanently lost. |
| Automatic Long-Term Gain Treatment: Heirs can sell immediately and still get the favorable long-term capital gains tax rates. | Legislative Risk: The rule is politically controversial and has been targeted for repeal or modification, making its future uncertain. |
| Benefits Family Businesses: It is critical for the succession of family farms and businesses, providing liquidity to the next generation without forcing a sale to pay taxes. | Doesn’t Apply to All Assets: It provides no benefit for retirement accounts like IRAs and 401(k)s, which are often a family’s largest assets. |
| Powerful Spousal Benefit: In community property states, the “double step-up” gives the surviving spouse incredible financial flexibility. | Unequal Geographic Treatment: The benefit for surviving spouses is significantly less valuable in the 41 common law states. |
The Process: How Heirs Secure the Step-Up in Basis
After a loved one passes away, the executor of the estate and the heirs should take these steps to properly document the new basis.
- Gather Key Documents: The first step is to obtain the official death certificate. This legal document is required by financial institutions to begin the process of retitling and revaluing assets.
- Determine the Fair Market Value (FMV): Every asset must be valued as of the date of death.
- For publicly traded stocks and mutual funds, this is the average of the high and low trading price on that day. Brokerage firms can provide this information.
- For real estate, private business interests, or valuable collectibles, you must hire a qualified professional appraiser to prepare a formal, retroactive appraisal report. Do not rely on Zillow or tax assessments, as the IRS can easily challenge them.
- Notify Financial Institutions: Contact the brokerage firms, banks, and other custodians where the assets are held. You will need to provide the death certificate and other required paperwork to have the assets retitled into the name of the estate, trust, or heir.
- Request a Basis Update: Specifically instruct the financial institution to update the cost basis of the inherited securities to the fair market value on the date of death. They may have a specific form for this. Keep meticulous records of this valuation for future tax filings.
- File Required IRS Forms: If the estate is large enough to require filing a federal estate tax return (Form 706), the executor must also file Form 8971 with the IRS. This form reports the final estate tax value of the property to the IRS and provides a schedule to each beneficiary showing the value of the assets they are inheriting. This ensures the basis is consistent between the estate and the beneficiaries.
Frequently Asked Questions (FAQs)
Does a step-up in basis avoid estate tax?
No. The step-up in basis relates to capital gains income tax for the heir. The estate tax is a separate tax on the total value of a person’s estate at death, which applies only to very large estates.
What happens if an asset has lost value?
No. The basis “steps down” to the lower market value at the date of death. This is a disadvantage because the capital loss that could have been claimed by the original owner is permanently erased.
Do assets in a trust get a step-up in basis?
Yes, if it is a revocable living trust. Assets in most irrevocable trusts designed to be outside the taxable estate do not get a step-up, according to a 2023 IRS ruling.
Can I choose not to take the step-up?
No. The basis adjustment under IRC § 1014 is mandatory, not elective. It applies automatically to all qualifying inherited assets, whether the value goes up or down.
Is the step-up in basis a tax loophole?
Yes, it is often described that way by critics. It is a legal provision in the tax code, but it allows billions of dollars in capital gains to escape taxation entirely, primarily benefiting wealthier households.
How do I prove the basis to the IRS if I didn’t get an appraisal at the time of death?
You should hire a certified appraiser to perform a retroactive or historical appraisal. While more difficult, it is the most authoritative evidence. Other records like tax assessments or comparable sales can be used but may be challenged.
Does the step-up apply to my 401(k) or IRA?
No. Retirement accounts are a major exception. They are considered “Income in Respect of a Decedent” (IRD), and beneficiaries must pay ordinary income tax on all distributions they take from these accounts.