When someone passes away, one of the most important tax rules that comes into play is something called the “step up in basis.” While the tax code is quite complex, this topic is actually pretty straightforward. And it’s great news for a Decedent’s Beneficiaries.
Let’s break down what the step up in basis is and how it works. We’ll also discuss some assets that the step up does not apply to. If you’re the Executor of a loved one’s Estate, a Successor Trustee, or just curious about the tax effects of your legacy, this article is for you.
Defining the Step Up in Basis
In simple terms, the step up in basis is a tax adjustment to the fair market value of certain assets when the owner dies. This is thanks to Internal Revenue Code § 1014. When someone owns an asset for many years, it will generally appreciate. This is especially so for assets like real estate here in Middle Tennessee.
The step up applies to “capital assets.” Most assets we own are capital assets, unless the tax code specifically excludes something. We’ll discuss some of these exceptions later.
The asset’s “basis” for tax purposes is generally what the Decedent paid for it. There can also be adjustments for improvements or investments made into the asset. But we won’t go into all those nuances here.
Normally, when the owner of a capital asset (such as a house, stock, or a business) sells it, capital gains tax applies to the difference between the purchase price and the sale price. This assumes, of course, there is a gain from the sale.
But upon the owner’s death, the tax code allows the basis of capital assets to receive a “step up” to the fair market value as of the date of death. This adjustment significantly reduces capital gains taxes for the Decedent’s Beneficiaries. In many cases, the step up completely wipes out taxable gain.
Example: Step Up for The Family Home
Let’s say your father bought his primary residence in Murfreesboro for $100,000 in 1995. The house is now worth $750,000.
If he sold the house now, he would have a capital gain of $650,000. While a special tax provision excludes $250,000 of that gain, the remaining $400,000 is subject to capital gains tax.
But let’s say you inherit the home after he passes away. You then sell it shortly after for $750,000. In this case, you won’t owe any capital gains tax. That’s because your basis “stepped up” to the date-of-death value, which was $750,000.
Without the step up, you’d be taxed on $650,000 of gain. With the step up, the gain is zero.
Step Up in Basis for a Brokerage Investment Account
Here’s another example. Suppose your mother has a taxable investment account holding various shares of stock. She paid $50,000 total for those shares over the years. The account is now worth a total of $250,000.
If she sells all of the stock during her lifetime, she would have capital gain of $200,000 and a hefty tax bill to pay.
But let’s say she holds onto it and gives it to you through a transfer-on-death beneficiary designation. Your tax basis in the brokerage account is whatever the value of the account was on the date of her death. All of the stocks held get “stepped up” to their publicly listed price on that day.
So if you sell the investments a few months later, and the value of the account is $260,000, your capital gain is only $10,000. Without the step up in basis, you would have capital gain of $210,000.
Assets That Do Not Get a Step Up in Basis
It’s important to know that not everything qualifies for the step up in basis. Here are some common assets that do not receive this tax benefit:
- 401(k) and other employer-sponsored retirement plans
- Traditional IRAs
- Roth IRAs (they grow tax-free, but don’t receive a step up)
- Annuities
- Cash or bank accounts (there’s no gain to adjust)
The tax code categorizes retirement accounts, like the 401(k) and Traditional IRA, as income in respect of a decedent (IRD). Distributions from these assets are ordinary income to the Beneficiary and are subject to ordinary income taxes.
So while a house or share of stock gets a favorable capital gains adjustment, a Traditional 401(k) or IRA is fully taxable when withdrawn. This is the case even though the retirement accounts can hold the exact same investments as a brokerage account.
How This Fits Into Probate and Trust Administration
During probate and trust administration, it’s essential to identify which assets receive a step up in basis and which do not. This helps the Executor or Trustee to:
- Accurately report asset values for tax purposes
- Avoid unnecessary capital gains taxes on inherited assets
- Account for income taxes that may be due from IRD assets
- Provide correct basis information to the Beneficiaries
Failing to track tax basis properly can lead to costly tax consequences or disputes later on.
We’re Here to Assist
If you’ve recently lost a loved one, you’re likely dealing with a lot—grief, legal paperwork, financial decisions, and more. We can help lighten the load.
Understanding how the step up in basis works is just one part of navigating probate and estate administration correctly. At Connell Law, PLLC we guide families in through every step of the process with clarity and care.
Request a free consultation with us today to get proper guidance on carrying out your loved one’s wishes.
