Step-Up in Basis: Common Questions Answered

A step-up in basis can make a major difference when someone inherits appreciating assets such as real estate, stocks, bonds, or mutual funds. It affects how capital gains are calculated and can significantly reduce the taxes owed when inherited property is eventually sold.

Understanding when a step-up in basis applies, how inherited property can be sold, and how the new basis is determined can help families make better decisions when planning an estate.

What Is a Step-Up in Basis?

When an asset appreciates in value and is sold, capital gains tax is generally calculated using the difference between the asset's basis and its sales price.

Your basis is typically what you originally paid for the asset. If you give an appreciating asset, such as a house, to someone during your lifetime, your basis generally transfers with the property.

For example, if a parent gives a house to a child while the parent is still alive, the child receives the parent's basis. If the child later sells the property, the capital gain is based on the difference between that original basis and the eventual sales price.

Inheritance works differently. If the parent keeps the property until death and the child inherits it, the child's basis generally steps up to the property's value at the date of death.

If the property is then sold for approximately that same value, there may be little or no capital gain because very little appreciation occurred after the new basis was established.

Does Inherited Property Have to Leave a Trust Before It Is Sold?

No. The step-up in basis applies upon death. The property does not have to be distributed from the trust or estate before it can be sold.

An asset can be sold directly from the trust or estate, or it can be distributed to the beneficiaries and sold by them.

From a tax standpoint, there generally is not much difference between the trust or estate selling the asset and the beneficiaries selling it directly. The bigger difference is often the administration.

If a house is distributed equally to three siblings, all three may have to agree on the sale and sign the necessary paperwork. If the property remains in the trust and one sibling is serving as trustee, that trustee can handle the sale and then distribute the proceeds to the beneficiaries.

Beneficiaries may receive the sales proceeds along with a Schedule K-1 for their tax return. Even if no capital gains tax is ultimately owed, the sale still needs to be reported.

Do Assets in an Irrevocable Trust Receive a Step-Up in Basis?

An irrevocable trust can create a very different result.

In the past, certain estate planning strategies attempted to remove assets from someone's personal estate by placing them in an irrevocable trust while still allowing heirs to receive a stepped-up tax basis after death.

That tax treatment is no longer available in the way it once was described.

When an asset is placed into an irrevocable trust and separated from the owner's estate, the heirs generally do not receive the same stepped-up basis that they would have received if the asset had remained part of the estate until death.

That can create a tradeoff. An irrevocable trust may be used to accomplish specific goals involving separation from a person's estate or creditor and liability protection, but those benefits can come at the cost of tax advantages associated with inherited assets.

For that reason, irrevocable trusts are typically used to accomplish a particular estate planning objective rather than simply as a place to put every asset.

How Is the New Step-Up in Basis Determined?

The method depends on the type of asset.

For publicly traded securities such as stocks, determining the value can be relatively straightforward because the value at the date of death can be identified.

Real estate requires more documentation. At a minimum, a competitive market analysis may help establish the property's value, but an appraisal can provide a more accurate picture of what the property was worth at the date of death.

That documentation matters because the IRS can question the value used on a tax return. If that happens, the beneficiaries or estate may need evidence showing how the new basis was calculated.

The same principle can apply to other appreciating assets, including fine art or jewelry.

Why Does Step-Up in Basis Matter for Estate Planning?

For many families, step-up in basis becomes especially important when a family home or other appreciated property passes from parents to children.

Allowing an appreciated asset to pass through inheritance rather than transferring it during the owner's lifetime can substantially change the capital gains calculation for the person receiving it.

That makes step-up in basis an important part of passing wealth from one generation to the next.

When considering whether to give appreciated property to children now or allow them to inherit it later, pay close attention to the tax basis. From a capital gains perspective, allowing the asset to pass after death may leave the children in a much better position.