One of the most powerful income tax benefits in the Internal Revenue Code is also one of the least understood: the step-up in basis for inherited assets under IRC §1014.

When a beneficiary inherits an asset, the cost basis is generally reset to the fair market value of the asset on the date of the decedent's death. Decades of unrealized capital gain are permanently eliminated. A stock purchased for $5,000 that is worth $500,000 at death passes to the beneficiary with a $500,000 basis — and if the beneficiary sells it immediately, there is no capital gain.

But the step-up rule has important exceptions, limitations, and planning implications that are frequently misunderstood.

Under IRC §1014(a), the basis of property acquired from a decedent is generally the fair market value of the property at the date of the decedent's death.

"Acquired from a decedent" includes:

• Property passing by bequest, devise, or inheritance;
• Property acquired through a trust that was includible in the decedent's gross estate;
• Property acquired by the surviving spouse under a qualified terminable interest property (QTIP) trust;
• Property acquired from a decedent by reason of death, form of ownership, or other conditions; and
• Property acquired through a revocable living trust.

The step-up applies to the entire fair market value at death — not just the appreciation that occurred during the decedent's ownership. If the decedent purchased property for $100,000 and it was worth $500,000 at death, the beneficiary's basis is $500,000, regardless of when the appreciation occurred.

The executor may elect to value the estate's assets as of the alternate valuation date — six months after the date of death — rather than the date of death, if:

1. The election reduces the gross estate; and
2. The election reduces the estate tax liability.

If the alternate valuation date is elected, the basis of inherited assets is generally the fair market value on the alternate valuation date (or the date of distribution, if distributed before the alternate valuation date).

The alternate valuation date election is available only when it reduces both the gross estate and the estate tax. It cannot be used solely to increase the basis of inherited assets.

The step-up rule works in both directions. If the fair market value of an asset at death is less than the decedent's basis, the beneficiary's basis is stepped down to fair market value.

This means that unrealized losses in the decedent's estate are also eliminated at death. A stock purchased for $100,000 that is worth $20,000 at death passes to the beneficiary with a $20,000 basis — the $80,000 unrealized loss is gone.

Planning implication: If a decedent holds assets with unrealized losses, it may be better to sell those assets before death to recognize the loss on the decedent's final return, rather than allowing the loss to disappear at death.

Not all assets inherited from a decedent receive a stepped-up basis. The following are important exceptions:

Income in Respect of a Decedent (IRD) is income that the decedent had a right to receive but had not yet received at death. IRD does not receive a step-up in basis.

Common examples of IRD:

• Traditional IRA and 401(k) distributions — the entire distribution is ordinary income to the beneficiary; there is no step-up;
• Deferred compensation — amounts deferred under a nonqualified deferred compensation plan;
• Installment sale proceeds — payments received after death on an installment sale the decedent entered into before death;
• Accrued interest — interest accrued but not yet paid on bonds or savings accounts;
• Accounts receivable — amounts owed to a cash-basis taxpayer for services rendered before death.

IRD is included in the beneficiary's gross income when received. The beneficiary is entitled to a deduction under IRC §691(c) for the estate tax attributable to the IRD — but this deduction does not eliminate the income tax on the IRD itself.

Assets transferred to an irrevocable trust during the grantor's lifetime are generally not included in the grantor's taxable estate and do not receive a step-up at death. They carry the grantor's original basis.

This is a critical planning consideration. A grantor who transfers highly appreciated assets to an irrevocable trust to remove them from the taxable estate may be trading an estate tax benefit for a loss of the step-up — which could result in significant capital gains tax when the trust eventually sells the assets.

In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin), both halves of community property receive a step-up at the death of either spouse — not just the decedent's half. IRC §1014(b)(6).

This is a significant advantage over separate property states, where only the decedent's share receives a step-up. Married couples in community property states should consider whether assets are properly characterized as community property to maximize the step-up benefit.

Traditional IRAs, 401(k)s, 403(b)s, and other pre-tax retirement accounts do not receive a step-up in basis. The entire account balance is IRD — ordinary income to the beneficiary when distributed.

The SECURE Act (2019) and SECURE 2.0 Act (2022) significantly changed the distribution rules for inherited retirement accounts. Most non-spouse beneficiaries must now distribute the entire account within 10 years of the decedent's death (the "10-year rule"), with no required minimum distributions in years 1 through 9 under proposed regulations (though this remains subject to IRS guidance).

Roth IRAs also do not receive a step-up in basis — but Roth distributions are generally tax-free to the beneficiary, so the absence of a step-up is irrelevant in most cases.

Hold appreciated assets until death. The step-up eliminates unrealized capital gains at death. Selling appreciated assets before death triggers capital gains tax; holding them until death eliminates that tax permanently. This is the most fundamental estate planning strategy involving the step-up.

Sell loss assets before death. Unrealized losses disappear at death. If the decedent holds assets with significant unrealized losses, selling them before death allows the decedent to recognize the loss on the final return.

Consider community property characterization. Married couples in community property states should ensure that appreciated assets are properly characterized as community property to obtain the full step-up on both halves at the first death.

Be cautious about transferring appreciated assets to irrevocable trusts. The estate tax benefit of removing assets from the taxable estate must be weighed against the loss of the step-up. For assets with significant unrealized appreciation, the capital gains tax cost of losing the step-up may exceed the estate tax savings.

Coordinate with the inherited IRA distribution strategy. Because inherited IRAs are fully taxable as ordinary income, the distribution strategy — timing, amounts, and Roth conversion opportunities — deserves careful planning.

The step-up in basis is one of the most powerful income tax benefits available to families transferring wealth across generations. Understanding which assets qualify, which do not, and how to plan around the exceptions can produce substantial tax savings.

If you are administering an estate, advising a beneficiary, or planning your own estate, contact us to discuss how the step-up rules apply to your specific situation.

Governing authority: IRC §§691, 1014, 2032; Treas. Reg. §1.1014-1 through 1.1014-8; IRS Publication 559; SECURE Act (Pub. L. 116-94); SECURE 2.0 Act (Pub. L. 117-328).

Related: Tax Implications of Inherited Investment Accounts · Form 1041 vs. Form 706 · Distributable Net Income