Understanding Stepped-Up Basis in Real Estate
Navigating the financial aspects of an inheritance can be complex, especially when real estate is involved. One of the most important concepts to understand is the “stepped-up basis.” This tax provision can have a significant impact on the amount of tax an heir owes when they eventually sell an inherited property. Let’s break down what stepped-up basis is, how it works, and how it connects to gift and estate taxes.
What is Basis in Real Estate?
Before diving into the “stepped-up” part, it’s essential to understand “basis.” In simple terms, the basis of a property is its original cost for tax purposes. This includes the purchase price; plus certain closing costs and the cost of any significant improvements made to the property over the years (like a new roof or a room addition).
For example, if you bought a house for $200,000 and spent $50,000 on a major renovation, your adjusted basis would be $250,000. This basis is the starting point for calculating capital gains when you sell the property.
How Stepped-Up Basis Works
When an individual inherits a property after the owner’s death, the basis is typically “stepped up” to the fair market value of the property at the time of the owner’s death. This means the heir’s basis is not the original purchase price but the property’s current value.
There are several ways to structure the transfer of real estate at death to ensure the heir(s) benefit from the stepped-up basis:
- Will (Testamentary Transfer): If the property passes through a will, the beneficiaries receive the property upon the owner’s death, along with a stepped-up basis to the property’s market value as of the date of death.
- Revocable Living Trust: Real estate held in a revocable living trust will also typically receive a stepped-up basis at death. After the trust becomes irrevocable upon the grantor’s death, the trust assets, including real estate, pass to the trust’s beneficiaries with the adjusted basis.
- Joint Tenancy with Right of Survivorship (JTWROS): If a property is owned in joint tenancy, upon the death of one owner, the surviving co-owner(s) automatically acquire the decedent’s share. Generally, the surviving owner receives a stepped-up basis on the portion of the property attributable to the deceased owner.
- Transfer on Death (TOD) Deed / Affidavit: In some states, a TOD deed / affidavit allows property owners to name beneficiaries who automatically inherit real estate at death, while bypassing probate. The inherited property is eligible for the stepped-up basis.
These methods allow heirs or surviving owners to take advantage of the stepped-up basis rule, which can result in significant capital gains tax savings if the property is sold soon after inheritance.
This rule is a major benefit for heirs. It essentially erases the capital appreciation that occurred during the deceased owner’s lifetime, reducing or even eliminating the capital gains tax if the heir decides to sell the property shortly after inheriting it.
Example:
Imagine your mother bought a beach house in 1990 for $100,000. Over the years, she made no major improvements. When she passes away, the house is valued at $700,000.
- If she had sold the house right before her death, she would have faced capital gains tax on the $600,000 profit ($700,000 sale price – $100,000 basis).
- However, because you inherit the property, your basis is stepped up to $700,000. If you turn around and sell the beach house for $710,000 a few months later, you only owe capital gains tax on the $10,000 of appreciation that occurred after you inherited it ($710,000 sale price – $700,000 stepped-up basis).
This provision can save heirs tens or even hundreds of thousands of dollars in taxes.
Gifting Real Estate vs. Inheriting: The Tax Difference
The concept of stepped-up basis highlights a critical distinction between receiving property as a gift versus an inheritance.
When you receive a property as a gift, you also receive the giver’s original basis. This is known as “carryover basis.” There is no step-up in value.
Example:
Let’s use the same beach house scenario. Instead of waiting to pass it on as an inheritance, your mother decides to gift you the house while she is still alive.
- The house is worth $700,000, but your basis is her original basis of $100,000.
- If you later sell the house for $710,000, your taxable capital gain would be a staggering $610,000 ($710,000 sale price – $100,000 carryover basis).
This is why, from a purely capital gains tax perspective, inheriting a highly appreciated asset is often more favorable than receiving it as a gift.
Gift Tax Considerations
When gifting property, the person giving the gift (the donor) may be required to file a gift tax return. For 2025, an individual can gift up to $18,000 per person per year without triggering gift tax implications. Any amount above that reduces the donor’s lifetime gift and estate tax exemption. While the recipient generally does not pay gift tax, the carryover basis can lead to a significant tax bill for them down the road.
The Connection to Estate Tax
Stepped-up basis is also linked to the federal estate tax. The estate tax is a tax on a person’s assets after their death. For an estate to be subject to this tax, its total value must exceed a very high exemption amount set by the government. In 2025, this exemption is $13.61 million per individual.
Because of this high threshold, the vast majority of estates do not owe any federal estate tax. The assets, including real estate, are included in the deceased’s estate to determine its total value. If the estate is below the exemption amount, the assets pass to the heirs, and they still benefit from the stepped-up basis without any estate tax being paid.
In the rare cases where an estate is large enough to owe estate tax, the property’s fair market value is used for both calculating the estate tax and establishing the heir’s new stepped-up basis.
Key Takeaways
- Inheritance: When you inherit real estate, your basis is “stepped up” to the property’s fair market value at the time of the owner’s death. This minimizes or eliminates capital gains tax if you sell it soon after.
- Gifts: When you receive real estate as a gift, you take on the giver’s original basis (“carryover basis”), which can result in a large capital gains tax liability upon sale.
- Estate Planning: The difference between gifting and inheriting has significant tax consequences. Understanding stepped-up basis is crucial for effective estate planning, both for those who own property and for their potential heirs.
Consulting with a financial advisor or an estate planning attorney can provide personalized guidance to ensure you make the most informed decisions for your unique situation. Reach out to our attorneys at Yonas & Phillabaum Attorneys at Law should you need assistance on this topic or most other legal topics at ypattorneys.com or call at 513-427-6100.
This is not legal advice; this is a legal advertisement.
