What Is a Step-Up in Basis?

Step-up in basis is a tax provision that adjusts the cost basis of an inherited asset to its fair market value on the date of the previous owner’s death.This adjustment is important because the cost basis determines the taxes owed when the asset is sold. The cost basis starts with the asset’s purchase price plus any additional costs incurred for improvements or maintenance over time.

When the market value of an inherited asset is higher than its original purchase price at the time of the owner’s death, the cost basis increases. The tax code allows for raising 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 various types of financial assets, including stocks, bonds, mutual funds, real estate, and other tangible properties.

However, if the market value of an asset has decreased since the owner’s purchase, the asset’s cost basis would step down instead of stepping up for heirs.

In practice, most inherited assets 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 favorable 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 market value on the previous 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.

• • Critics argue that the benefits of the step-up in basis primarily favor wealthy households, leading to efforts to limit or eliminate the provision in recent years, without success.

How Does Step-Up in Basis Work?

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 Jane purchases a share of stock at $2 and dies when its market price is $15. Had Jane sold the stock before dying at $15, she (or her estate after her death) would be liable for capital gains tax on a gain of $13.

Instead, her heir’s cost basis becomes $15 so that if the stock is later sold at that price no capital gains tax would be due. The tax that would have been incurred on the increase from $2 to $15 is effectively eliminated.

Tax basis is the cost of an asset to its owner, as calculated and adjusted for tax purposes. It is used to assess capital gains, depreciation, amortization, and depletion.5

Step-Up in Basis in Community Property States

Residents of nine community property states, including California, can use the double step-up in basis rule. This allows a step-up in basis for community property—assets accumulated during marriage, excluding 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, while 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 and 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.

For instance, consider Ann and Bill, a hypothetical married couple in a common-law state. They hold stock worth $200,000 in a joint brokerage account with a cost basis of $100,000 at the time of Bill’s death. Under common law principles, Ann would receive a step-up in basis on Bill’s half of the account, valued at $100,000, but not on her half. Therefore, the tax basis for the stock would rise to $150,000 instead of $200,000, as it would in community property states.

Any surviving spouse in the U.S. is entitled 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 wealthy families. The Congressional Budget Office (CBO) estimates that over half the aggregate benefit accrues to the top 5% of taxpayers by income. In 2020, the CBO estimated the provision’s cost in foregone tax revenues at $110 billion over 10 years.

Some supporters argue that eliminating the step-up in basis could disincentivize saving and result in double taxation when combined with the federal estate tax. Following the 2017 federal estate tax exemption doubling, only 0.04% of adult deaths in 2020 triggered estate tax liability.

In 2021, a proposal backed by President Joe Biden and some Democrats to eliminate the step-up in basis for assets exceeding $2.5 million (plus $250,000 for a home) for a married couple 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 is subtracted from the sale price to calculate the capital gains tax liability.

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 states without community property provisions, jointly owned property, such as stock in a joint brokerage account, receives only half the step-up in cost basis compared to what it would receive in a community property state.

Is Step-Up in Basis a Tax Loophole?

The step-up in basis is a legally established provision of the U.S. tax code, though it is certainly responsible for a significant loss of public revenue. The provision is often viewed critically because the exemption from capital gains taxes on assets held until death disproportionately benefits the wealthiest households.

The Bottom Line

The step-up in basis is a valuable tax provision that allows inherited assets to have their cost basis adjusted to their fair market value at the time of the previous owner’s death. This adjustment can significantly reduce capital gains taxes for heirs when they sell the asset. However, this provision has drawn criticism for benefiting primarily wealthy households because they can pass on substantial assets without incurring capital gains taxes.