Stepped-up basis: the number that decides what an inherited house costs in tax

Basis is the least intuitive word in this entire subject and the most important one. It is the figure subtracted from what a property sells for in order to work out the gain. High basis, small gain. Low basis, large gain. Nothing else in the calculation moves the answer as far.

For property bought in the ordinary way, basis starts as what was paid for it and is adjusted over the years of ownership. For property acquired from someone who has died, a different rule applies — and it is the single largest tax fact about an inherited house.

What the rule actually says

Internal Revenue Code section 1014 provides that the basis of property in the hands of a person acquiring it from a decedent is the fair market value of the property at the date of the decedent's death. Publication 551, the IRS's guide to basis, states the same rule in its own words: the basis of property inherited from a decedent is generally the fair market value of the property at the date of the individual's death.

The effect is easy to state and hard to overstate. Whatever the person paid for the house, and however much it appreciated across the decades they owned it, that appreciation does not carry forward to the heirs as taxable gain. The clock is reset. Gain, if there is any, is measured only from the date of death onward.

The alternatives to the date-of-death value

Section 1014 lists a small number of substitutes for the date-of-death figure. They are worth knowing about mainly so they are not mistaken for the general rule.

• The alternate valuation date. If an election is made under section 2032, the property is valued at the date that section prescribes rather than at the date of death. It is available only where a federal estate tax return is filed, and the Form 706 instructions condition it on the election decreasing both the value of the gross estate and the estate and generation-skipping transfer taxes payable. Property distributed, sold, exchanged or otherwise disposed of within six months after the death is valued on the date of that disposition instead.
• Special-use valuation. Under section 2032A, qualified real property used in farming or another closely held business can be valued on the basis of that use rather than at fair market value, if the personal representative elects it. Where that happens the special-use value becomes the qualified heir's basis, and an additional estate tax can be recaptured if the property is disposed of, or stops being used that way, within ten years of the death.
• A qualified conservation easement. To the extent value is excluded from the taxable estate under the rule for those easements, the decedent's own basis carries over instead of a new one being set.

For the large majority of families none of these is in play, because none of them is reachable without a federal estate tax return or a working farm. The date-of-death fair market value is the number.

Where that number comes from — and this is the part that gets lost

Publication 523, the IRS's guide to selling a home, is unusually direct about the source of the figure. If a federal estate tax return was filed or was required to be filed, the value of the property listed on that return is the basis. If no estate tax return had to be filed, the basis is the appraised value of the home at the date of death for purposes of state inheritance or transmission taxes.

Most estates are nowhere near large enough to require a federal estate tax return, so for most families it is the second sentence that operates — and it points at an appraisal that nobody is compelled to obtain. The valuation is a fact about one particular day. Evidence of it is at its most available close to that day, from a licensed appraiser who can value the property as of the date of death, and it becomes progressively harder to establish as the gap widens. Families who sell in year six are frequently trying to prove a year-one number.

Jointly owned property steps up only in part

Where a house was owned jointly, only the share that belonged to the person who died takes a new basis. Publication 523 sets out the surviving spouse's position: the basis of the interest the late spouse owned becomes its fair market value on the date of death, the basis of the survivor's own interest is unchanged, and the new basis in the home is the sum of the two. Where a home was held as tenants by the entirety, or as joint tenants with right of survivorship, each is treated as having owned one half.

There is an exception to that split, and it depends entirely on where the couple lived. In the states that use a community property system, the IRS's guidance is that when either spouse dies the total value of the community property — including the part belonging to the surviving spouse — generally becomes the basis of the entire property, provided at least half its value is includible in the decedent's gross estate. Whether a given family is in one of those states has a real answer and a large consequence, and it is not an answer an article written for the whole country can give.

Two more rules that surprise people

• The holding period is long term automatically. Publication 559: if you sell or dispose of inherited property that is a capital asset, the gain or loss is considered long term, regardless of how long you held the property. An heir who sells three weeks after the death is not producing a short-term gain.
• Property given to the person shortly before they died may not step up at all. If appreciated property was given to an individual within the one-year period ending on that individual's death, and the donor or the donor's spouse then acquired the same property back from them, the basis is the decedent's adjusted basis immediately before death rather than the date-of-death value.

Why this is worth understanding rather than delegating entirely

The step-up is not something anyone applies for, and it cannot be forfeited by failing to file a form. It happens by operation of the statute, silently, on the date of death. What can be lost is the evidence of the number — and with it the ability to demonstrate, years later, that a sale produced little or no gain. That is a records problem rather than a tax problem, and it is created or avoided in the first few months.

Everything above is the federal rule as the IRS publishes it. How it lands on a particular property — how it interacts with a trust, a life estate, a fractional interest, or depreciation taken during a period when the home was rented — is a question for a CPA or an enrolled agent with the documents in front of them, and it is a question worth asking while the appraisal is still obtainable.