Step-Up in Basis: Why Inherited Property Is Taxed Differently

Few tax rules matter more to heirs than this one, and few are explained less clearly. If you inherit a house, stocks, or land and later sell it, the “basis” you use can change how much tax you owe, sometimes by tens of thousands of dollars. Here’s how the rule works, where it doesn’t apply, and what to keep.

What is basis?

Basis is, roughly, the starting value the tax system uses to measure your gain when you sell. The IRS explains that if you sell inherited property for more than your basis, you have a taxable gain. If you sell for less, you may have a loss. The IRS notes that the gross proceeds from the sale of inherited property are included in gross income when considering whether you need to file, with the sale reported on Schedule D and Form 8949.

What is the “step-up”?

The IRS says the basis of property inherited from a decedent is generally one of two values:

• The fair market value (FMV) on the date of the decedent’s death, whether or not the executor files an estate tax return (Form 706)
• The FMV on the alternate valuation date, but only if the executor files Form 706 and elects to use alternate valuation on that return

Because FMV at death is often higher than what the person originally paid, the heir’s basis is “stepped up,” and the appreciation that built up during the decedent’s lifetime isn’t taxed as a gain to the heir. If the property is worth less than the decedent paid, the basis is “stepped down” to the lower value.

A simple example (ours, for illustration): A parent bought a house for $100,000 decades ago. At death it’s worth $400,000. The heir’s basis is generally $400,000. If the heir sells it for $410,000, the taxable gain is generally $10,000, not $310,000.

How do I find the date-of-death value?

The IRS says to contact the executor for the FMV on the date of death. If the estate was required to file Form 706, beneficiaries generally receive a Schedule A (Form 8971) from the executor reporting the estate tax value of property distributed to them. If you didn’t receive a Schedule A, Publication 551 says your basis can be determined using the appraised value at the date of death for state inheritance or transmission tax purposes. In practice, get a qualified appraisal as of the date of death for real estate, a business, or collectibles, and keep brokerage statements for securities. For special situations such as special-use valuation of farm or business real property, see Publication 551 and the Form 706 instructions.

What about community property?

Publication 551 explains that in community property states, married individuals are each usually considered to own half of the community property, and that when either spouse dies, the total value of the community property, even the part belonging to the surviving spouse, generally becomes the basis of the entire property. Its example: community property with a basis of $80,000 and an FMV of $100,000 at the first spouse’s death gives the surviving spouse a basis of $50,000 in their half, plus the inherited half stepped up. The result is a new basis for both halves. Texas and California are among the community property states. Check your state’s rules; this is a place where a tax professional pays for itself.

What about property owned jointly?

Rules differ. For property that spouses owned as a “qualified joint interest,” Publication 551 explains that the surviving spouse’s basis is the cost of their own half (with adjustments), increased by the basis of the half they inherited. In other words, generally only the half included in the decedent’s estate gets stepped up. Property held with someone other than a spouse follows different rules; see Publication 551 and ask a professional.

What doesn’t get a step-up?

• Retirement accounts and other “income in respect of a decedent.” IRD includes unpaid wages, deferred compensation, and traditional IRA and 401(k) balances, income the person earned or was entitled to but hadn’t received. Publication 559 has a section on it, and a ThinkAdvisor article explains that, unlike most estate assets, IRD assets don’t receive a new basis at death. See inheriting an IRA or 401(k)
• Property you or your spouse gave the decedent shortly before death. The IRS says that if you or your spouse gave the property to the decedent within one year before the decedent’s death, see Publication 551, because special rules apply
• Property given away during life is generally treated differently from property inherited, and the recipient generally takes over the giver’s basis; ask a professional

What is “consistent basis” reporting?

Since 2015, the IRS explains, Congress has required that in certain circumstances the recipient’s basis in inherited property be consistent with the value as finally determined for federal estate tax purposes. An executor required to file Form 706 files Form 8971 and gives each beneficiary a Schedule A. The Form 8949 instructions say that if you received a Schedule A and it indicates the property increased the estate tax liability, you must report a basis consistent with the final estate tax value. The IRS adds that an accuracy-related penalty may apply if a basis higher than the property’s final estate tax value is used (Notice 2016-27). For most estates, which owe no estate tax, this doesn’t come up.

Is inherited property treated as long-term?

Tax guides generally say yes: inherited assets are treated as held long term, so any gain on a sale shortly after the death qualifies for long-term capital gains rates. Confirm with your tax professional, since the details can depend on the facts.

What should I keep?

• The appraisal or date-of-death valuation
• Schedule A (Form 8971), if you received one
• Brokerage statements showing date-of-death values
• Records of improvements and selling costs
• Your communications with the executor about values

See do you pay taxes on an inheritance? and estate tax vs. inheritance tax.

For how to find out what belongings are worth, see How estate sales work (and how to find out what belongings are worth).

This is general educational information, not tax advice. Basis rules have exceptions and depend on how property was owned and what state you live in; a tax professional can address your situation. The example is for illustration only.