How does step-up in basis at death work and how should it influence planning?

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AcadiFi · Accepted Answer

Step-up in basis is a tax provision under IRC Section 1014 that resets the cost basis of inherited property to its fair market value on the decedent's date of death...

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Mechanics: suppose Evelyn Harrow holds $2 million in publicly traded stock with a $300,000 original basis — $1.7 million unrealized gain. If she sells during life, she pays LTCG tax on $1.7M × 23.8% = $404,600. If she instead holds until death and her heirs inherit, basis steps up to $2 million market value; heirs selling immediately pay zero capital gains tax — the $404,600 liability vanishes.

Assets that receive step-up: publicly traded securities, real estate, privately held business interests (though valuation is contestable), artwork and collectibles, most tangible personal property. In community-property states like California and Texas, both spouses' halves step up when one spouse dies, delivering full reset versus common-law states where only the decedent's half steps up.

Assets that do NOT receive step-up: traditional IRA assets (distributions remain ordinary income), 401(k) assets, annuities (only contract value resets, not income in respect of decedent), and gifts received during lifetime (carry-over basis applies).

Optimal planning implications: (1) hold highly appreciated assets until death when possible rather than realizing gains during life; (2) donate low-basis assets to charity (deduction at full market value, no capital gains realized); (3) consume high-basis assets first when drawing retirement income; (4) in community property states, delay reset triggers like joint-tenancy severance; (5) reconsider harvesting gains when age and life expectancy suggest step-up is achievable.

```mermaid
flowchart LR
  A[Asset at Death] --> B[FMV on Date]
  B --> C[Basis Reset]
  C --> D[Heirs Sell]
  D --> E[No Cap Gain]
```

Trade-offs and risks: estate tax may apply for estates above the federal exemption ($13.6M in 2024), potentially offsetting income tax savings. Some policy proposals would eliminate step-up or impose capital gains at death. For CFA Level III, quantify the after-tax benefit of holding-until-death versus realizing-and-reinvesting, recognizing the trade-off between current income needs and tax efficiency at death. For clients approaching late retirement with adequate non-appreciated assets for living expenses, maximizing step-up is typically the most valuable tax strategy available.

How does step-up in basis at death work and how should it influence planning?

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