What You Need to Know About Stepped-Up Tax Basis

Alright, guys, this is a bit of a dry subject, but it’s extremely important to understand for anybody who inherits property from a family member or loved one upon their unfortunate passing. 

A stepped up tax basis on property you inherit is a way to reduce your tax burden.

This is a vast simplification of stepped-up tax basis, but it should give you a foundation for understanding your options should you inherit property. Please note that nothing here should be construed as financial advice in any way. Any further consideration of this subject should happen between you and your tax attorney. 

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When selling property that one has inherited, one pays a capital gains tax based upon the property’s current value. Because property almost never goes down in value over long periods of time, most people who inherit property will inherit property currently valued much higher than it was when initially purchased. Upon the death of the original property owner and its passing to the new owner, the cost basis of the property is adjusted up from its initial sale price to its current fair market value. The inflation in value that the property has seen since its initial purchase is the capital gain on the property, and the new owner is taxed based upon that gain when they choose to sell the property.

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So, let’s say a parent purchased property in 1985 for $100K. At the time of their death in 2022, it was worth $2M. If the heirs sell the property when it transfers to them, the capital gain on the property will be $1.9M, or its current value minus its initial purchase price. The capital gains tax on that property will be assessed upon $1.9M.

A step-up in basis is the way around paying a capital gains tax on this $1.9M. 

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Upon the death of the decedent, the tax code affords the ability to raise the cost basis (upon which capital gains taxes are determined) to its current value as opposed to its initial sale price. This is called a step-up in basis. A step-up in basis means that the cost basis of the property is reset at the time of the decedent’s death to its current value so that its capital gains prior to inheritance are essentially wiped away for the person who inherits the property. 

Back to our example: After a step-up in basis, the inherited property– initially purchased for $100K and valued at $2M at the time of the decedent’s death– has its cost basis reset to $2M. As a result, if the property is sold for $2M, one does not have to pay a capital gains tax based upon the $1.9M that it has risen in value, but instead pays capital gains against its new cost basis ($2M) and its sale price (in this example, also $2M). So, rather than paying a capital gains tax on $1.9M, one pays a capital gains tax on $0.

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Many blogs and articles out there try to hedge around this subject and play coy with it, but I’m going to be straight with you: if this seems like a tax loophole, that’s because it is. It’s fully legal and built into the United States tax code, but there’s no reasonable mistaking that it is an enormous tax handout to people who inherit property. And the more property one inherits, the bigger a benefit it is to them. However, the wealthiest people in this country have fought for this massive financial handout, and one would be foolish not to accept it, given its legality. 

Again, this has been a huge simplification of a complicated tax process, and must not be considered financial advice. You should discuss any such financial decisions and maneuvering with your tax attorney.