Understanding Step-Up in Basis: A Key Tax Benefit for Inheritors

When inheriting property, one significant financial advantage that can impact your tax obligations is the “step-up in basis.” This tax provision can reduce the capital gains tax you may owe when you sell an inherited asset. Understanding how a step-up in basis works and how to apply it can save substantial money in taxes.

What is Step-Up in Basis? The step-up in basis is a tax rule that adjusts the value of an inherited property for tax purposes upon the death of the original owner. Instead of the property’s original purchase price, the basis of the property is “stepped up” to its fair market value at the date of the owner’s death.

How Does Step-Up in Basis Work?

1. Determine the Original Basis: This is typically what the original owner paid for the property, including any improvements made during their ownership.
2. Assess the Fair Market Value: At the time of the owner’s death, the property’s fair market value is appraised.
3. Adjust the Basis: The property’s basis is adjusted to this fair market value, which becomes the new basis for the inheritor.

Example: Suppose a parent bought a home for $150,000 and it’s worth $400,000 at the time of their passing. If you inherit this home, the basis is stepped up to $400,000. If you sell the home for $400,000, you would owe no capital gains tax because there is no gain over the stepped-up basis.

Benefits of Step-Up in Basis:

• Reduces Tax Liability: By stepping up the basis, the taxable gain on the sale of inherited property is minimized.
• Simplifies Record Keeping: Inheritors don’t need to track down the original purchase price and improvement costs of the property.

Limitations and Considerations:

• Estate Size: The step-up in basis may be limited in very large estates that exceed the estate tax exemption amounts. (In 2024, the federal estate tax exemption amount is set to $13.61 million per individual. This means that an individual can leave up to $13.61 million to heirs and pay no federal estate tax. For married couples, the exemption is effectively doubled to $27.22 million. This adjustment is part of an annual update to account for inflation.)
• Legislative Changes: Tax laws are subject to change, and there have been proposals to modify or eliminate the step-up in basis rule.

How to Claim a Step-Up in Basis: When you inherit a property, obtaining a professional appraisal at the time of the original owner’s death is advisable to substantiate the stepped-up basis. Keeping thorough documentation is crucial, especially if you plan to sell the asset.

The step-up in basis is a valuable tax provision that can significantly reduce the capital gains tax due when selling inherited property. By accurately understanding and applying this rule, inheritors can manage inherited properties more effectively and optimize their financial outcomes.

• IRS Publication 551 (Basis of Assets): https://www.irs.gov/publications/p551
• Investopedia’s Guide on Step-Up in Basis: https://www.investopedia.com/terms/s/stepupinbasis.asp