Understanding the Step-up in Basis for Assets Acquired from an Inheritance

Feb 13, 2024
Estate Planning

When it comes to inheriting assets, a critical concept that can profoundly affect your financial situation is the step-up in basis. This term pertains to the adjustment in the tax cost basis of inherited assets to their fair market value at the time of the original owner's death. A clear comprehension of the step-up basis is vital for heirs and beneficiaries, as it can have significant implications for capital gains taxes when an asset is sold. 

What is Step-Up in Basis?

The basis of an asset is the value from which capital gains taxes are calculated when you sell the asset. In some situations, when you inherit an asset, the IRS provides a favorable tax benefit known as the step-up in basis. This means that the value of the inherited asset for tax purposes is adjusted to its fair market value on the date of the original owner’s death.

For example, if you inherit a family home that was purchased for $100,000 (the original owner’s tax cost basis) but is now worth $500,000 at the time of the owner’s death, your new tax basis for the property is $500,000. This adjustment erases any potential capital gains tax liability on the appreciation in the property’s value that occurred during the original owner’s lifetime (if the property were sold immediately after inheriting it).

Implications for Capital Gains Tax

The step-up in basis can have significant income tax benefits for heirs. When you sell the inherited asset, you will only owe capital gains tax on any increase in value that occurs after the date of inheritance. In our previous example, if you sell the inherited home for $550,000, you will only owe capital gains tax on the $50,000 increase in value since the date of the inheritance, rather than the $450,000 increase in value from the original purchase price by the original owner.

Understanding the Step-up in Basis for Assets Acquired from an Inheritance | AmeriEstate Legal Plan

Some Exceptions and Limitations

The step-up in basis is typically a favorable tax benefit for heirs; there are some exceptions and limitations to understand:

Jointly Owned Property

If you inherit property that was jointly owned with the deceased, only the portion owned by the decedent receives the step-up in basis (unless the asset is considered a community property asset).

Inherited IRAs and Retirement Accounts: Inherited traditional IRAs and retirement accounts do not receive a step-up in basis. Withdrawals from these accounts are typically subject to income tax.

Special Use Valuation

In some cases, certain farms or closely held businesses may qualify for a special use valuation, which can affect the step-up basis calculation.

Understanding the step-up in basis is crucial for individuals who are to inheriting assets. This tax benefit has the potential to substantially diminish capital gains tax liabilities, offering financial benefits to heirs. It is important to seek guidance from legal and tax professionals to navigate the intricate landscape of various taxes, to make the most of the step-up in basis.

Estate Planning