When you inherit property or investments from a loved one, you may be focused on the sentimental value of the property or the financial opportunity the assets represent. But there’s an important tax concept that can make a huge difference in how much you ultimately keep of what you inherit: the step-up in basis.
Understanding how step-up in basis works can save you from a potentially hefty capital gains tax bill and preserve more of the family wealth that the original owner intended to pass on.
What is step-up in basis, and how does it apply to inherited assets?
When someone passes away and leaves tangible assets to their heirs – such as real estate, stocks or other investments – the IRS allows those assets to receive a “step-up” in their cost basis to whatever their fair market value was at the time of its prior owner’s death – instead of what it was when the prior owner purchased those assets.
This ultimately can reduce or even eliminate the capital gains taxes an heir owes when the asset is sold. Here’s what that would look like in practice:
- Before inheritance: If your parents bought a house for $100,000 thirty years ago and it’s now worth $400,000 due to inflation and improvements, their cost basis was $100,000.
- After inheritance: When you inherit the home, the cost basis “steps up” to the fair market value at the date of their death, or $400,000.
This is critical because it resets the amount of potential capital gains that would be taxable if you decide to sell. It’s important to note that the cost basis can also be “stepped down” if the property decreased in value, but that is seldom applicable.
Without the step-up, an heir could be stuck paying capital gains taxes on decades of an asset’s appreciation – even if they never benefited from that growth. With the step-up, most or all of that unrealized financial gain is erased for tax purposes. For example, following the example above:
- If you sold the house soon after inheriting it for $410,000, your taxable gain would only be $10,000 (the difference between $410,000 sale price and $400,000 stepped-up basis).
- Without a step-up, your taxable gain would be $310,000 (sale price minus the original $100,000 basis).
As you can see, the difference in taxes owed could easily amount to tens of thousands of dollars. The greater the inheritance, the more profound the potential tax savings.
What assets qualify for a step-up in basis?
The step-up generally applies to assets that are included in the deceased person’s estate, such as:
- Real estate (primary residences, vacation homes, rental properties)
- Stocks, bonds and mutual funds
- Business interests and holdings
- Other capital assets, like art, collectibles or even intellectual property
It’s important to note that retirement accounts like IRAs or 401(k)s do not get a step-up in basis, because they are taxed differently.
What can you do to make the most of the step-up in basis? Whether you’re thinking ahead for your heirs or you’re anticipating an inheritance, it is wise to:
- Keep good records: Knowing the original cost basis helps confirm the step-up amount with the IRS.
- Get a professional appraisal: Especially for real estate, an appraisal at the time of inheritance can help document the fair market value.
- Consider timing: If you’re planning to sell inherited property, selling soon after inheriting can minimize further taxable gain.
- Coordinate with your estate plan: Proper titling of assets and use of trusts can help ensure your heirs receive the maximum benefit.
The step-up in basis is one of the most powerful tax breaks available to heirs. It can dramatically reduce the tax burden and preserve more wealth. Because estate and tax laws can change (and the step-up in basis has become somewhat controversial), it’s wise to review your estate plan regularly with a qualified attorney and tax advisor.
