Step-Up in Basis: Why Inherited Assets Are Taxed Differently

Imagine your parent bought 500 shares of a company stock back in 1985 for $10 per share. By the time they pass away, those shares are worth $200 each. If they had sold before death, the taxable gain would have been enormous. But you inherit the shares, and your accountant tells you there may be little or no tax owed if you sell right away. How is that possible?

The answer lies in a provision of the U.S. tax code known as the step-up in basis. This rule resets the cost basis of an inherited asset to its fair market value on the date of the original owner's death. It is one of the most consequential and least understood rules in American tax law, with real implications for both people inheriting assets and those doing the planning now.

This article walks through exactly how the rule works, uses a concrete example to make the math clear, explores what it means for holding concentrated positions, and covers two critical exceptions: retirement accounts and community property states.

Before getting to the step-up, it helps to understand what cost basis means. In straightforward terms, your cost basis is what you paid for an asset. When you sell it, the IRS calculates your taxable gain by subtracting your basis from the sale price.

For example, if you bought 100 shares of stock at $20 per share, your basis is $2,000. If you later sell for $5,000, your taxable capital gain is $3,000. Depending on how long you held the asset, that gain is taxed at either short-term rates (ordinary income rates, which can reach 37%) or long-term rates (0%, 15%, or 20%, depending on your income). The IRS publishes current capital gains tax brackets at irs.gov.

Now consider what happens when you inherit an asset instead of buying it yourself.

The step-up in basis rule is established under Internal Revenue Code Section 1014. When a person dies and passes assets to heirs, the basis of those assets is generally stepped up to their fair market value on the date of death, rather than the original purchase price the deceased paid.

Here is a hypothetical example to illustrate the difference:

• Original purchase: Margaret buys 500 shares of stock in 1990 at $8 per share. Her total cost basis is $4,000.
• Value at death: Margaret passes away in 2025, when the stock is worth $160 per share. The total value is $80,000.
• Without step-up (if Margaret had sold just before death): The gain would be $76,000 ($80,000 minus $4,000). At a 15% long-term capital gains rate, the tax bill would be $11,400.
• With step-up (inherited by her son David): David's cost basis is reset to $80,000, the fair market value on the date of Margaret's death. If David sells shortly after for $80,000, his taxable gain is $0. The $76,000 of appreciation built up over 35 years is not subject to capital gains tax.

This is not a loophole or oversight. It is a deliberate feature of the tax code, though one that has been debated by policymakers over the years. As of 2025, the rule remains in place. Note that this example is purely illustrative. Individual tax situations vary, and actual outcomes depend on many factors.

The step-up rule creates an interesting tension with one of the most common pieces of financial wisdom: diversify your concentrated positions. Standard guidance often suggests that holding a large amount of wealth in a single stock is risky, and that investors with concentrated positions consider selling and spreading that capital across a broader portfolio.

That advice has genuine merit from a risk management perspective. A single company can falter, and overconcentration in one position leaves little cushion. However, the step-up in basis introduces a tax dimension that some people and their advisers weigh carefully.

Consider this: if a highly appreciated asset is sold during the owner's lifetime, a substantial capital gains tax is owed immediately. After that tax is paid, the remaining capital is reinvested. But if the asset is held until death and passed to heirs, the gain built up during the owner's lifetime is effectively erased for tax purposes. Heirs receive the asset with a fresh, higher basis.

For individuals who have concentrated stock positions and who are in good health and financially comfortable without needing to sell, the step-up rule is a factor that qualified advisers sometimes incorporate into long-term estate planning discussions. The trade-off is real: accepting continued concentration risk in exchange for a potentially significant tax advantage for heirs. There is no universally correct answer, and it is worth discussing with both a financial adviser and an estate planning attorney who can evaluate the full picture.

Here is where many people are caught off guard. Retirement accounts, including traditional IRAs, 401(k)s, 403(b)s, and similar pre-tax accounts, do not receive a step-up in basis at death.

The reason is structural. Money inside these accounts was never taxed when it went in (in the case of traditional pre-tax contributions), and the tax code treats withdrawals as ordinary income regardless of who takes them. When a beneficiary inherits a traditional IRA, they inherit the tax liability along with the assets.

Under the SECURE Act and its successor the SECURE 2.0 Act, most non-spouse beneficiaries who inherit retirement accounts are now required to withdraw the full balance within 10 years of the original owner's death. Those withdrawals are taxed as ordinary income in the year they are taken. Depending on the beneficiary's income and the size of the account, this can result in a significant tax bill.

This distinction matters greatly for estate planning. Assets held in a taxable brokerage account receive the step-up; assets held in a pre-tax retirement account do not. Some people find it worthwhile to consider which assets to hold where as part of a broader strategy, a concept sometimes called asset location. Our post on retirement tax diversification across account types explores this idea in more detail.

Roth IRAs present a different scenario. Contributions to Roth accounts are made with after-tax dollars, and qualified withdrawals are generally tax-free. Inherited Roth IRAs are also generally free of income tax for beneficiaries, though the 10-year withdrawal rule still applies to most non-spouse heirs under current law. Even so, Roth accounts do not receive a step-up in basis in the traditional sense, because the concept of cost basis functions differently inside these accounts.

If you live in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), the step-up in basis works differently for married couples, and the difference can be substantial.

In community property states, assets acquired during marriage are generally considered owned equally by both spouses. When one spouse dies, the surviving spouse may receive a full step-up in basis on the entire asset, not just the deceased spouse's half. This is sometimes called a double step-up.

To illustrate with a hypothetical: suppose a married couple in California owns stock worth $200,000, originally purchased for $40,000 during their marriage. In a common-law state, the surviving spouse might only receive a step-up on the deceased spouse's half-share ($100,000 stepped up, $20,000 retaining its original basis). In a community property state, the entire $200,000 value may be stepped up, potentially eliminating capital gains tax on the full $160,000 of appreciation.

The rules here are nuanced and depend on how assets are titled and how state law interacts with federal tax rules. Couples who have moved between states or hold assets acquired before marriage face additional complexity. An estate planning attorney familiar with both state and federal law is well placed to help navigate this.

For anyone thinking about what they will eventually leave behind, the step-up in basis rule is worth building into your thinking. A few considerations that often come up in estate planning conversations include:

• Which assets to hold in taxable accounts versus retirement accounts: Assets with large unrealized gains may be candidates to hold in taxable accounts, where heirs benefit from the step-up. Retirement account assets pass with their tax liability intact.
• Gifting during your lifetime: When you gift an appreciated asset to someone while you are alive, your original cost basis transfers with it. The recipient does not get a step-up. This is a meaningful difference between gifting now versus leaving assets at death.
• Charitable giving strategies: Donating appreciated assets to charity is often more tax-efficient than selling first and donating the proceeds, since capital gains tax is generally not owed when appreciated property goes directly to a qualified charity.
• Keeping good records: Heirs will need documentation of the fair market value at the date of death to establish the stepped-up basis. Working with an estate administrator and ensuring proper valuation records are kept can save significant hassle later.

If you are thinking about how to structure your estate more broadly, the interplay between step-up rules and trust structures is another area where professional guidance tends to pay for itself.

It is also worth keeping an eye on legislative developments. Proposals to modify or eliminate the step-up in basis have been introduced in Congress in recent years, though none have been enacted as of 2025. The current rules could change, which is one more reason to work with an adviser who stays current on tax law.

This article is provided for general educational purposes only and does not constitute personalised financial, tax, or legal advice. Tax rules are complex and individual circumstances vary. Readers are strongly encouraged to consult a qualified financial adviser, CPA, or estate planning attorney before making any decisions based on the information here.