Legal Definitions - Stepped-up basis

Stepped-up basis is a tax rule that adjusts the cost of an inherited asset for capital gains tax purposes. When someone inherits property or other assets, this rule allows the asset's "cost basis" to be reset, or "stepped up," to its fair market value on the date of the previous owner's death.

This adjustment is significant because capital gains tax is calculated based on the difference between an asset's selling price and its cost basis. By stepping up the basis to the market value at the time of inheritance, the inheritor typically faces a much smaller capital gain, or sometimes even a capital loss, if they sell the asset shortly after inheriting it. This can significantly reduce the amount of capital gains tax owed compared to if the inheritor had to use the original purchase price of the asset as its basis.

Here are a few examples to illustrate how stepped-up basis works:

• Example 1: Family Home

  Maria's parents purchased their family home in 1975 for $50,000. Over the decades, the property's value increased significantly. When Maria's last parent passed away in 2023, the home was appraised at $800,000. Maria inherited the house and decided to sell it a few months later for $815,000. Because of the stepped-up basis rule, Maria's cost basis for the home became $800,000 (its value at the time of inheritance). Therefore, her capital gain for tax purposes is only $15,000 ($815,000 selling price - $800,000 stepped-up basis). Without this rule, her capital gain would have been $765,000 ($815,000 selling price - $50,000 original purchase price), resulting in a much higher tax bill.

• Example 2: Collectible Art

  David's aunt was an avid art collector who bought a unique sculpture in 1990 for $10,000. By the time she passed away in 2022, the sculpture had become highly sought after and was valued at $250,000. David inherited the sculpture. A year later, he decided to sell it at auction for $260,000. Due to the stepped-up basis, David's cost basis for the sculpture was reset to $250,000. When he sold it, his taxable capital gain was only $10,000 ($260,000 selling price - $250,000 stepped-up basis). If the stepped-up basis rule didn't apply, David would have been taxed on a capital gain of $250,000 ($260,000 selling price - $10,000 original purchase price).

• Example 3: Investment Portfolio

  Sarah inherited a diversified portfolio of mutual funds from her grandfather. He had originally invested $150,000 into these funds over many years. At the time of his passing, the portfolio had grown to a market value of $700,000. Sarah decided to hold onto the investments for a while, but eventually sold a portion of the portfolio for $720,000. Thanks to the stepped-up basis, the cost basis for the inherited portion of the portfolio was reset to $700,000. When Sarah sold it, her capital gain for tax purposes was $20,000 ($720,000 selling price - $700,000 stepped-up basis), rather than the much larger gain that would have been calculated from her grandfather's original $150,000 investment.