Stepped-up basis is a tax rule that adjusts the fair market value (FMV) of inherited real estate to the value on the date of the owner’s death. Instead of inheriting the original purchase price, heirs receive the property with a new cost basis equal to its FMV at death. That reset can sharply reduce or eliminate capital gains taxes when the heir later sells the property.
How it works
When a property transfers at death, the heir’s cost basis is “stepped up” (or down) to the property’s FMV at the date of death. Capital gains on a later sale are computed using this stepped-up basis, not the deceased owner’s original purchase price.
Key formula:
Capital gains owed = (Selling price − Stepped-up basis) × Capital gains rate
Examples
- Family home: Parent bought a house in 1980 for $100,000. At death its FMV is $500,000. The child inherits with a stepped-up basis of $500,000. Selling right away for $500,000 triggers no capital gains tax. Selling later for $550,000 results in tax only on the $50,000 gain.
- Spouses (community property states): In community property states, both spouses’ shares typically receive a step-up when one dies. If a couple bought a home for $400,000 and it’s worth $600,000 at one spouse’s death, the surviving spouse’s basis for the entire property becomes $600,000, greatly reducing taxable gain if sold soon after. (In non-community-property states, usually only the deceased spouse’s share is stepped up.)
- Rental property: A fully depreciated rental bought for $40,000 is valued at $320,000 at one spouse’s death. The surviving spouse inherits the deceased’s half at a stepped-up basis of $160,000. If sold shortly thereafter, taxable gain is minimized; the owner may also be able to depreciate the stepped-up building basis going forward for rental tax purposes.
Why it matters
- Tax savings: Appreciation that occurred during the decedent’s lifetime generally escapes capital gains tax, which can save heirs substantial amounts.
- Estate planning: Knowing how stepped-up basis works is central to wills, trusts, and beneficiary decisions to preserve family wealth. See estate planning.
- State law differences: Rules vary between community property and common-law states and affect how much of a property’s basis is stepped up.
Limitations & important caveats
- Property given as a gift during life does not receive a stepped-up basis—the recipient generally inherits the donor’s original basis, which can lead to larger capital gains when sold.
- If the surviving spouse keeps the property until their death, a second stepped-up basis may occur for the next generation.
- Proper valuation and documentation at the time of death are essential to substantiate the stepped-up basis for IRS and state tax purposes.
Bottom line
Stepped-up basis is a powerful tax provision for inherited real estate: it resets the heir’s basis to the property’s FMV at death, often eliminating capital gains that accrued during the decedent’s lifetime. It influences decisions about gifting vs. bequeathing property, spousal ownership strategies, and overall estate planning. For specific situations and state-law nuances, consult a tax professional or estate planner.
