Understanding the Cost Basis of an Asset

When is There a Step-Up in Cost Basis?

Understanding the concept of cost basis is crucial to effective estate and tax planning. An asset's cost basis is the value of the asset when you acquired it. The difference between the value at which you acquired the asset and the value at which you sold the asset represents your capital gain (or loss) and is used to determine your tax liability. For example, if you bought one share of stock Y at $10, your cost basis would be $10. If you sell your share of stock Y three years later for $50, then your capital gain is $40.

Cost basis is typically the value at which the asset is acquired, with a notable exception when it comes to inherited assets. When you inherit an asset from someone's estate after they pass away, the cost basis for that asset typically becomes the fair market value at the time of their death. This is called a "step-up" (although less common, it can also be a "step-down"). For example, say your Grandmother purchased a share of stock X for $5. If your Grandmother passes away and you inherit the stock at a point when its market value is $50, your cost basis is $50 rather than $5. If you sell the stock two years later for $70, your capital gain is $20.

Not all assets receive this step-up in cost basis. Below is a broad overview of the treatment of different assets. Please consult with your estate or tax professional for more details.¹

Assets that typically do not receive a step-up in cost basis:

• Annuities: Receive no step-up in basis and any gains will be taxed as ordinary income.²
• Irrevocable Trusts: When property is given to an irrevocable trust, it is no longer included in the decedent's gross estate and does not qualify for the step-up in cost basis.⁸
• Transfer of Assets While Living: Transfers made while the transferring party is still alive generally do not qualify for the step-up in cost basis.⁶
• Savings Bonds: Unlike many other securities, Savings Bonds do not qualify for the step-up in cost basis.⁷

Assets that typically do receive a step-up in cost basis:

• Individual Stocks and Bonds²
• Significant Home Improvements: With receipts and records, major home renovations can add to the existing cost basis of the house. This does not include painting or other minor changes.⁴
• Mutual Funds²
• Art and Furnishings²
• Collectibles²
• Real Estate²

Special Cases:

• 1 Year Holdings: Assets that were gifted to the decedent must have been held for at least one year prior to their passing in order for those assets to receive a step-up in cost basis when they are inherited.⁵
• Joint Property: For most jointly held property, only the portion owned by the deceased receives the step-up in cost basis. However, in a community property state, both portions are stepped up to fair market value.⁵ A list of community property states is available here.

Important things to note:

Alternative Valuation Date: For estates that might be subject to estate tax, one can utilize the alternative valuation date. This allows the estate to value assets six months after the decedent's passing, instead of on the date of death. It must be one or the other, not a date in between. Crucially, the alternative valuation date can only be used if it results in a reduction in the value of the gross estate.³

Long-Term Gains: The holding period for inherited assets is presumed to be long-term gains, regardless of the decedent's prior holding period. Critically, assets that were gifted to the decedent one year before his/her passing do not qualify for the step-up in cost basis.⁹

Value Can Go Down as Well: It is possible that, depending on market value at the time of the decedent's passing, an heir could receive a "step-down" in cost basis instead of a "step-up."¹

1. https://www.law.cornell.edu/wex/stepped-up_basis
2. https://www.fidelity.com/learning-center/personal-finance/what-is-step-up-in-basis
3. https://www.law.cornell.edu/uscode/text/26/2032
4. https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/property-basis-sale-of-home-etc-3
5. https://www.kitces.com/blog/step-up-in-basis-gifting-assets-spouses-estate-tax-unrealized-gains-separate-property-states/
6. https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/property-basis-sale-of-home-etc
7. https://karplaw.com/the-scoop-on-u-s-government-savings-bonds/
8. https://www.investopedia.com/terms/i/irrevocabletrust.asp
9. https://www.hrblock.com/tax-center/income/investments/holding-period/