Stepped-up basis

Under Internal Revenue Code § 1014(a), when a person (the beneficiary) receives an asset from a giver (the benefactor) after the benefactor dies, the asset often receives a stepped-up basis, which is its market value at the time the benefactor dies. A stepped-up basis is often much higher than the before-death cost basis, which is primarily the benefactor's purchase price for the asset. Because taxable capital-gain income is the selling price minus the basis, a high stepped-up basis can greatly reduce the beneficiary's taxable capital-gain income when the beneficiary sells the inherited asset.

Under IRC § 1014(a), which applies to an asset that a person (the beneficiary) receives from a giver (the benefactor) after the benefactor dies, the general rule is that the beneficiary's basis equals the fair market value of the asset at the time the benefactor dies. This can result in a stepped-up basis or a stepped-down basis. An example of a stepped-up basis: If Benefactor owned a home that Benefactor purchased for $35,000, then Benefactor's basis in the home would be equal to its purchase price, $35,000, assuming no adjustments under IRC § 1016, which allows for increases in basis such as home improvements, or decreases in basis such as unrepaired windstorm damage. Continuing the example, the fair market value of Benefactor's home was $100,000 on the day Benefactor died. After Beneficiary inherits the home from Benefactor, Beneficiary's basis in the home is that fair market value, $100,000. In contrast, if Benefactor gives the home to Beneficiary before Benefactor dies, then Beneficiary receives a carryover basis, which is equal to the Beneficiary's purchase price for the home, $35,000, again assuming no adjustments under IRC § 1016.

"Basis" is generally the amount you have invested in an asset. Thus, in the very simple case, if you buy a house for $35,000, your "basis" is $35,000.

"Gain", in the very simple case, is the amount you receive when you dispose of an asset, minus your basis in the asset. Thus, if you sold the house above for $100,000, your gain (what you might be taxed on) would be $65,000 (sales price of $100,000 minus your basis of $35,000), if we ignore complicating factors for purposes of this general example.

Normally, when someone receives an asset from you before you die, the person who receives the asset keeps the same basis in the asset that you, the donor, had. For example, if your sister Mary were to receive this house from you before you die, then her basis in the house would also be $35,000, no matter what the fair market value (FMV) of the house was on the date of the gift. Therefore, if your sister were to sell the house for $100,000, she would generally need to pay income tax on the $65,000 of capital-gain income.

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Wikipedia