What it means
Capital gains tax is charged on the difference between what an asset sells for and its basis, which is the tax term for what it cost you. Normally the basis follows the asset wherever it goes: buy shares for $10 and your basis stays $10 no matter how many years you hold them.
Death changes the arithmetic. When an asset passes through an estate, its basis is generally reset to market value at the date of death, so decades of appreciation are never taxed as income in the hands of the person inheriting it.
This matters enormously for family businesses, farms and long-held property. A founder who built a company from nothing has a basis close to zero, and without the reset the next generation would face tax on the entire value of the business simply for selling what they inherited.
The rule also shapes behaviour while people are alive. Advisers often suggest holding the most-appreciated assets until death and gifting cash or recently bought holdings instead, because a lifetime gift usually carries the original basis across to the recipient rather than resetting it.
Several limits are worth knowing. The adjustment works downwards too, so an asset that has fallen in value gets a step-down and the unrealised loss disappears, and assets held in certain trusts or in retirement accounts may not qualify at all.
The step-up is a feature of income tax rather than estate tax, so a large estate can still owe estate tax on the same asset.
In practice
Real-world examples.
Example
A widow inherits a rental property her husband bought for $120,000 in 1988 and which is valued at $610,000 on his death. She sells it the following spring for $625,000 and pays capital gains tax on only $15,000 rather than on more than half a million.
Example
A family that owns a printing business is advised not to gift shares to the children during the founder's lifetime, since the children would inherit the near-zero basis along with the shares. The plan is restructured so the shares pass through the estate instead.
Example
An investor holding a large technology position that has fallen well below its purchase price is told the step-up would work against his heirs, resetting the basis downwards and erasing an unrealised loss. He sells during his lifetime to preserve the loss for his own tax return.
Think of it
“Step-up in basis wipes out unrealized gains at death-heirs get a fresh start.
Formula
Calculation
Capital gain on sale by the heir = Sale price - Stepped-up basis, where Stepped-up basis = market value at the date of death
Robert bought shares in a manufacturing company for $80,000 in 1994. By the time he died they were worth $500,000, and his daughter inherited them and sold them eight months later for $520,000.
Without a step-up in basis, her taxable gain would be $520,000 - $80,000 = $440,000. At a 20% long-term capital gains rate, the tax would be $440,000 x 20% = $88,000.
With the step-up, her basis becomes the $500,000 date-of-death value. Her taxable gain is $520,000 - $500,000 = $20,000, and the tax is $20,000 x 20% = $4,000. The step-up has saved her $88,000 - $4,000 = $84,000, and the entire $420,000 of appreciation during Robert's lifetime escapes capital gains tax altogether.Case study
Seen in the real world.
Tallgrass Orchard Company is a fictional family farming business invented for this illustration. The founder bought 300 acres in 1971 for $180,000 and, by the time she died, development in the surrounding county had lifted the land value to roughly $4,200,000.
Her two children wanted to sell half the acreage to fund the modernisation of the packing operation on the rest. Without a step-up, selling $2,100,000 of land carrying a proportional basis of $90,000 would have created a gain of $2,010,000 and a tax bill large enough to swallow most of the reinvestment budget.
Because the basis stepped up to date-of-death value, the illustrative sale produced a gain of only the small movement in land prices since their mother's death. The story is invented, but the pattern is common in real succession planning: the step-up frequently determines whether a family business can restructure after a death or has to sell more than it wanted to in order to pay tax.
Watch out
Common mistakes.
- Assuming a step-up applies to assets given away during the owner's lifetime. Lifetime gifts generally carry the giver's original basis to the recipient, which is why timing matters so much.
- Believing the step-up wipes out all tax on an inheritance. It removes the built-in capital gain, but estate or inheritance taxes can still apply, and later growth is taxed normally.
- Forgetting that the reset can go down. Inheriting an asset worth less than the deceased paid for it loses the unrealised loss rather than preserving it.
Questions
People also ask.
Do retirement accounts get a step-up?
Generally not, because withdrawals from tax-deferred accounts are taxed as ordinary income to the beneficiary rather than as capital gains.
How is the date-of-death value established?
Usually by a professional valuation for property or a business, and by the quoted market price for listed securities, documented as part of the estate's records.
Should the heir sell straight away to take advantage of it?
Not necessarily, but selling soon after death means very little gain has accrued since the reset, which is why heirs often reorganise a portfolio at that point.
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