Step-up in basis refers to the adjustment in the cost basis of an inherited asset to its fair market value on the date of the decedent’s death. Cost basis is what determines the taxes owed, if any, when the asset is sold. Cost basis starts with the price paid for an asset, plus any additional costs added over time to improve or maintain the original asset.
Step-up in basis, or stepped-up basis, occurs when the price of an inherited asset on the date of the decedent’s death is above its original purchase price. The tax code allows for the raising of the cost basis to the higher price, minimizing the capital gains taxes owed if the asset is sold later.
The step-up in basis provision applies to financial assets like stocks, bonds, and mutual funds as well as real estate and other tangible property.
Of course, if the price of an asset has declined from that paid by the owner’s date of death, the asset’s cost basis would step down instead of stepping up for heirs.
In practice, most cost basis adjustments after death are steps up, not steps down. This is because financial assets passed on to heirs are often long-term holdings, while financial assets and real estate tend to have positive long-term rates of return.
Key Takeaways
- A step-up in basis resets the cost basis of an appreciated inherited asset for tax purposes.
- The cost basis for heirs is raised to the asset’s market value on the prior owner’s date of death, reducing future capital gains taxes.
- Residents of states with community property laws or those with assets in community property trusts qualify for a step-up in basis on community property for the surviving spouse.
- Because the benefits of the step-up basis mostly accrue to the wealthiest households, opponents have tried to limit or eliminate the provision in recent years, without success.
Understanding Step-Up in Basis
A step-up in basis resets the cost basis of an inherited asset from its purchase (or prior inheritance) price to the asset’s higher market value on the date of the owner’s death.
For example, let’s suppose Sarah purchases a share of stock at $5 and passes away when its market price is $20. Had Sarah sold the stock before dying at $20, she (or her estate after her death) would be liable for capital gains tax on a gain of $15.
Instead, her heir’s cost basis becomes $20 so that if the stock is later sold at that price no capital gains tax would be due. Capital gains tax that would have been due on the rise in the share price from $5 to $20 absent Sarah’s death is never collected.
Step-Up in Basis for Community Property States and Trusts
Residents of nine community property states, including California, can take advantage of the double step-up in basis rule. The rule provides a step-up in basis on community property—all assets accumulated during marriage other than inheritances and gifts—for the surviving spouse.
In other states, assets owned solely by the surviving spouse do not receive the step-up in basis, and jointly owned assets receive only half the step-up in basis they would receive in a community property state.
Alaska, Kentucky, South Dakota, and Tennessee allow residents as well as non-residents to create community property trusts qualifying held assets for community property tax treatment, including the double step-up in basis rule, under the federal tax code.
Consider Emma and John, a hypothetical married couple living in a common-law, rather than a community property state. They hold stock worth $250,000 in a joint brokerage account with a $125,000 cost basis at the time of John’s death. Under common law principles legislated in most states, Emma would be entitled to a step-up in basis on John’s half of the brokerage account, or $125,000 in current value, but not on her half. So the tax basis for stock held in the account would rise to $187,500 instead of $250,000 as in community property states or under community property trusts.
Note that the surviving spouse anywhere in the U.S. would be entitled like any other heir to the stepped-up basis on inherited assets previously owned solely by the deceased.
Step-Up in Basis as a Tax Loophole
The step-up in basis tax provision has often been criticized as a tax loophole for the wealthiest families. The Congressional Budget Office (CBO) has estimated over half the aggregate benefit accrues to the top 5% of taxpayers by income. In recent years, the CBO estimated the provision’s cost in foregone tax revenues at billions of dollars over a 10-year period.
Some defenders of the stepped-up basis have argued that eliminating it might provide a disincentive to save and subject estates to double taxation in combination with the federal estate tax. Following the doubling of the federal estate tax exemption in recent years, a modern-era record-low percentage of adult deaths produced an estate tax liability.
A proposal backed by some U.S. lawmakers that would have eliminated the step-up in basis for assets in excess of specific thresholds failed to secure congressional approval.
How Is Step-Up in Basis Calculated?
A step-up in basis resets the cost basis of an inherited asset to its market value on the decedent’s date of death. If the asset is later sold, the higher new cost basis would be subtracted from the sale price to calculate the capital gains tax liability, if any.
How Is Step-Up in Basis Treated Differently in Community Property States?
In community property states (and for assets in community property trusts) the surviving spouse receives a step-up in basis for community property. In the majority of states without community property provisions, jointly-owned property such as stock in a joint brokerage account would receive only half the step-up in cost basis compared with the same account in a community property state after the death of a spouse.
Is Step-Up in Basis a Tax Loophole?
The step-up in basis is a duly legislated provision of the U.S. tax code, though it is certainly responsible for a significant loss in public revenue. Because the exemption from capital gains taxes on assets held until death disproportionately benefits the wealthiest households, disparaging descriptions are likely to persist.
Related Terms: cost basis, community property states, estate tax.
References
- Internal Revenue Service. “Publication 551, Basis of Assets”. Page 2.
- Internal Revenue Service. “Publication 551, Basis of Assets”. Page 10.
- Internal Revenue Service. “Publication 551, Basis of Assets”. Pages 2, 10.
- Tax Foundation. “Step-Up in Basis”.
- Internal Revenue Service. “Topic No. 703 Basis of Assets”.
- Kitces. “Preserving Capital Losses At Death By Gifting Embedded Loss Assets To Avoid A Step-Down In Basis”.
- Kierman Law. “Community Property Trusts Frequently Asked Questions”.
- Committee for a Responsible Federal Budget. “Closing the Stepped-Up Basis Loophole”.
- Congressional Budget Office. “The Distribution of Major Tax Expenditures in 2019”. Page 14.
- Congressional Research Service. “Tax Treatment of Capital Gains at Death”. Page 1.
- Peter G. Peterson Foundation. “What Is the Stepped-Up Basis, And Why Does the Biden Administration Want to Eliminate It?”
- Tax Policy Center. “Taxable Estate Tax Returns as a Percentage of Adult Deaths, Selected Years of Death, 1934-2020”.
- Forbes Advisor. “What Investors Should Learn From the Failed Bid to End Stepped-Up Basis”.
