Capital Gains Tax on Inherited Property

When someone inherits property, the IRS resets the cost basis to its fair market value on the date of death — a benefit called a step-up in basis. Heirs owe capital gains tax only on appreciation that occurs after they inherit, not on gains that accumulated before the death.

The Step-Up in Basis Works Immediately

When an asset owner dies, the IRS allows their heirs to inherit with a refreshed cost basis. Instead of carrying forward the original owner’s purchase price or adjusted basis, each beneficiary takes a basis equal to the asset’s fair market value on the decedent’s date of death.

Example: A parent buys stock for $10,000. At death, it’s worth $150,000. The heir now has a basis of $150,000, not $10,000. If the heir sells immediately after inheriting, there’s no capital gains tax — the $150,000 gain accumulated before death vanishes from the tax code.

This reset applies to nearly all inherited assets: stocks, bonds, real estate, artwork, collectibles, and business interests. The exception is certain property acquired from a decedent before 2010 that the executor elected to carryover basis treatment for, which is rare and applies mostly to high-net-worth estates.

When Heirs Owe Capital Gains Tax

The heir triggers capital gains tax only when the inherited property appreciates after the inheritance date and is then sold. The taxable gain is the difference between the sale price and the stepped-up basis.

Example: An heir inherits a house valued at $400,000 on the date of death. Three years later, the heir sells it for $450,000. The taxable gain is $50,000, not the $400,000+ gain that accumulated before the decedent died.

The gain is automatically treated as a long-term capital gain, even if the heir held it for days. This matters because long-term gains qualify for preferential tax rates (0%, 15%, or 20% for federal tax purposes, depending on income), while short-term gains are taxed as ordinary income.

Property Held in Tenancy with Right of Survivorship

Real estate and securities held jointly with a right of survivorship receive special treatment. Only the deceased owner’s share of the property receives a step-up in basis. The surviving co-owner’s share retains the original basis.

Example: A married couple in a community property state holds rental real estate. The property cost $200,000 in the 1980s and is worth $600,000 when one spouse dies. In a community property state, the entire basis steps up to $600,000. In a non-community property state (tenancy by the entirety or joint tenancy), only the deceased spouse’s half steps up; the surviving spouse’s half still has a basis of $100,000 (half the original cost).

Community Property Treatment

Community property states — Arizona, California, Colorado, Idaho, Louisiana, Nevada, New Mexico, Texas, Utah, Washington, and Wisconsin — offer an additional advantage. Both halves of community property held between spouses receive a step-up in basis when either spouse dies, even though only one spouse’s interest technically passes to heirs.

This double step-up is significant for married couples in these states. Non-community property states use joint tenancy or tenancy by the entirety, which does not provide a step-up for the surviving spouse’s interest.

Inherited Assets Never Sold

A step-up in basis provides its greatest benefit when the heir never sells the inherited asset. The appreciation before death is permanently erased from taxation. This is why step-up in basis is sometimes called a “free pass” on decades of gains — the basis reset occurs regardless of whether the heir sells immediately or holds indefinitely.

Example: An heir inherits a rental property worth $800,000 and holds it for 20 years, collecting rent. Even if it appreciates to $2 million, the heir’s cost basis remains $800,000. If the heir’s child eventually inherits it, the basis steps up again to its value on the new heir’s date of death.

Inherited Retirement Accounts and Exceptions

Inherited IRAs, 401(k)s, and other qualified retirement plans do not receive a step-up in basis. The beneficiary inherits the pre-tax balance and must pay income tax on withdrawals at ordinary income rates (not preferential long-term capital gains rates). This is a critical exception to the step-up rule.

Non-qualified deferred annuities inherited by non-spouse beneficiaries also do not step up; the heir pays tax on the embedded gains when distributions are taken.

Inherited property in revocable living trusts steps up in basis the same way as probate property, but irrevocable trusts have different rules that may prevent a step-up.

The Impact on Estate Planning

The step-up in basis is why tax professionals sometimes advise high-net-worth individuals to hold appreciating assets until death rather than gift them during life. A gift during life carries the donor’s basis to the recipient; the recipient’s basis does not step up. But inheritance always triggers a step-up (with the exceptions noted above).

Example: A parent buys stock for $10,000 that is now worth $100,000. If the parent gifts the stock to an adult child, the child’s basis is $10,000, and any future sale will trigger a $90,000 gain (minus any appreciation after the gift). If the parent holds the stock until death and the child inherits it, the child’s basis is the value at death — say $150,000 — and the entire $140,000 pre-death gain is erased.

This is why inherited assets should generally not be sold immediately without checking the stepped-up basis, and why gifting highly appreciated property is often tax-inefficient compared to allowing it to be inherited.

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