Understanding Step-Up in Basis at Death: Implications and Exclusions
The concept of a “step-up in basis” at death is one of the most significant—and often misunderstood—features of the U.S. tax system. For families with appreciated assets, it can dramatically reduce or even eliminate capital gains taxes for heirs. However, its application is not universal, and several important exclusions and nuances can materially impact planning decisions.
This article provides a detailed examination of how the step-up in basis works, when it applies, where it does not, and how it should influence financial and estate planning strategies.
What is Step-Up Basis At Death
The step-up in basis refers to the adjustment of an asset’s tax basis to its fair market value (FMV) at the date of the owner’s death. This adjustment effectively erases unrealized capital gains that accumulated during the decedent’s lifetime.
An investor purchases stock for $100,000. At death, the stock is worth $300,000 for a solid $200,000 gain. If the investor sells the stock during life, they may owe taxes on the $200,000 gain.
However, at death, the heir inherits the stock with a new basis of $300,000. If the heir sells immediately, there is no taxable gain.
This provision applies broadly to many different types of assets but generally is limited to assets that are considered non-qualified. Most commonly, it applies to:
- Homes
- Taxable Investments (see Understanding Tax Implications for Investment Accounts – Gilbert Wealth)
- Real Estate
- Businesses
From a planning perspective, this provision often drives decisions around whether to sell assets during life, gift them, or retain them for estate transfer.
Excluded Items
There are multiple items that fall outside of this valuable tax benefit.
Retirement Accounts (IRAs, 401(k)s)
Assets held in retirement accounts such as Traditional IRA’s, Roth IRA’s, 401k’s, 403b’s, etc do not receive a step up in basis.
Instead, the heirs inherit the accounts largely with the same tax implications of the original owner.
Pre-tax money in these accounts are taxed as ordinary income while after-tax money is withdrawn tax free.
If you pass a $1,000,000 Traditional IRA to an heir that has $500,00o of gains, the heir is still going to be taxed at ordinary income rates for each withdrawal.
Income recognition can be spread out over the course of withdrawals.
Assets in Irrevocable Trusts
Whether assets in a trust receive a step-up depends on how the trust is structured.
- Revocable living trusts: Typically included in the estate → step-up applies
- Irrevocable trusts: May be excluded from the estate → no step-up
See What Is a Revocable Living Trust and Do You Need One? – Gilbert Wealth
Non-Qualified Annuities
Non-qualified annuities – annuities not in a retirement account – do not receive a step-up in basis at death. Instead, they are treated as income in respect of a decedent (IRD), meaning any deferred gains remain fully taxable to the beneficiary when withdrawn.
Unlike stocks or real estate, where unrealized appreciation can be eliminated at death, the earnings inside a non-qualified annuity retain their original tax character as ordinary income, not capital gains.
Community Property vs Common Law States
In community property states, both halves of community property may receive a step-up in basis upon the death of one spouse
In common law states, only the deceased spouse’s portion typically receives a step-up
Gifts Made Before Death
Assets transferred during life do not receive a step-up in basis.
Gifting highly appreciated assets may inadvertently pass on large embedded tax liabilities