Understanding Inherited Asset Taxation & Stepped-Up Basis
The Stepped-Up Basis Rule: A Huge Tax Benefit
One of the largest tax benefits in the U.S. tax code is the "stepped-up basis" rule. When you inherit an asset, your cost basis (for capital gains tax purposes) is "stepped up" to its fair market value on the date of the deceased's death—not what the deceased originally paid. This means if someone bought stock for $10,000 in 1990 and it's worth $500,000 when they die, you inherit it with a $500,000 basis. If you sell it immediately for $500,000, you have $0 capital gain and owe $0 capital gains tax. The deceased's $490,000 gain completely disappears. This rule saves heirs billions in taxes annually and is a major incentive for holding appreciated assets until death. Understanding this rule helps you make smart decisions about inherited assets: sell immediately (no tax), hold for appreciation (pay tax on future gains), or donate to charity (no tax, charitable deduction).
Key Tax Concepts
Stepped-Up Basis: When you inherit an asset, your starting cost basis is its fair market value on the date the owner died. This is true regardless of what they paid for it. Example: Deceased bought property for $100K in 1980, it's worth $500K when they die. Your basis is $500K. You immediately sell for $500K = $0 gain = $0 tax. The $400K appreciation escapes taxation forever.
Capital Gains Holding Period: To get preferential long-term capital gains rates (0%, 15%, or 20% federal), you must hold the inherited asset more than 1 year. However, inherited assets are treated as long-term by default, even if you sell them immediately. This is another tax benefit: you get long-term rates without the 1-year holding period.
Long-Term Capital Gains Rates (2024): 0%, 15%, or 20% depending on your income. Single filers: 0% up to $47,025, 15% from $47,025-$518,900, 20% above. Married filing jointly: 0% up to $94,050, 15% from $94,050-$583,750, 20% above. If you're in a low income bracket, you might owe 0% tax on inherited asset sales.
Depreciation Recapture: If the inherited asset is investment real estate that claimed depreciation deductions, you must "recapture" that depreciation at 25% tax rate. If property claimed 15 years × $5,000/year depreciation = $75,000 depreciation, you owe 25% × $75,000 = $18,750 recapture tax, separate from capital gains tax.
Net Investment Income Tax (NIIT): An additional 3.8% tax applies to net investment income (including capital gains) for high earners. Thresholds: single $200K, married $250K. If your total NII exceeds thresholds, the excess is taxed an additional 3.8%.
State Capital Gains Tax: Some states impose additional capital gains taxes (0-13.3% depending on state). California has 13.3%, New York 8.82%, some states have 0%.
Tax Impact: Inherited Assets vs. Other Assets
| Scenario | Basis | Sale Price | Gain | Federal Tax (15%) | Net to You |
|---|---|---|---|---|---|
| Inherited Asset (stepped-up) | $500K | $525K | $25K | $3,750 | $521,250 |
| Non-Inherited Asset (purchased at $100K) | $100K | $525K | $425K | $63,750 | $461,250 |
| Difference (stepped-up benefit) | +$400K basis | — | $400K less gain | $60,000 less tax | $60,000 more to you |
Worked Example: Inherited Real Estate in California
Scenario: You inherit a rental property purchased by deceased in 1995 for $200K. It's now worth $750K. You sell it 6 months later for $760K. The property had $150K in depreciation deductions claimed.
TAX CALCULATION:
- Stepped-Up Basis: $750K (FMV at death)
- Sale Price: $760K
- Capital Gain: $760K - $750K = $10K
- Federal Capital Gains Tax (15%): $10K × 15% = $1,500
- Depreciation Recapture (25%): $150K × 25% = $37,500
- California Capital Gains Tax (13.3%): ($10K + $150K) × 13.3% = $21,280
- Total Tax: $1,500 + $37,500 + $21,280 = $60,280
- Net Proceeds: $760K - $60,280 = $699,720
COMPARISON (if deceased had sold):
- Original Basis: $200K
- Gain: $760K - $200K = $560K
- Federal Tax (15%): $560K × 15% = $84,000
- Depreciation Recapture (25%): $150K × 25% = $37,500
- California Tax (13.3%): ($560K + $150K) × 13.3% = $94,490
- Total Tax: $215,990
- Net Proceeds: $760K - $215,990 = $544,010
TAX SAVINGS FROM STEPPED-UP BASIS: $155,710 Just by dying, the deceased avoided $155K in taxes that you avoid inheriting.
Strategic Decisions for Inherited Assets
1. Sell Immediately (Maximize Stepped-Up Basis)
Best if: You don't want to manage the asset; the stepped-up basis eliminates taxes. The asset has appreciated significantly post-inheritance; you want to avoid future capital gains.
Tax impact: You pay tax only on gains after death. Deceased's gains escape entirely.
Consideration: If selling quickly, ensure it's truly step-up timing and not subject to any holdback taxes.
2. Hold and Manage (for income or appreciation)
Best if: Asset generates income (rental property, dividend stocks); you expect further appreciation; you want long-term growth.
Tax impact: You pay tax on future gains only (gains after death). Income from the asset (rent, dividends) is taxable to you annually.
Consideration: Holding doesn't change your stepped-up basis, but future appreciation will be taxable.
3. Donate to Charity (Avoid Tax Entirely)
Best if: You're charitably inclined; the stepped-up basis is "good enough" but appreciation is expected; you want tax deduction.
Tax impact: No capital gains tax; you get charitable deduction equal to asset's FMV. This is extremely tax-efficient for appreciated assets.
Consideration: You lose the asset but get tax benefits. Excellent for assets with huge appreciation.
Important Limitations & Assumptions
- This calculator uses 2024 federal tax rates; rates change annually with inflation adjustments.
- Capital gains rates depend on your total taxable income and filing status. This calculator uses your marginal bracket as a proxy.
- State taxes vary dramatically (0% to 13.3%). Check your specific state rate.
- NIIT (3.8%) applies only if your NII exceeds thresholds. Lower earners may not be subject.
- Depreciation recapture applies only to investment real estate or certain business property. Not applicable to personal residences.
- Special rules apply to certain assets (collectibles, small business stock). This calculator uses standard rates.
- Some inheritances may be subject to federal estate tax if the deceased's estate exceeded $13.61 million (2024). This calculator assumes the asset itself wasn't subject to estate tax.
Next Steps for Inherited Asset Planning
1. Identify Your Assets: List all inherited assets, their FMV at death, and original cost basis. Understand which generate income (taxable annually).
2. Calculate Tax Liability: Use this calculator to estimate taxes on potential sales. Understand the stepped-up basis benefit.
3. Decide on Timing: Immediate sale? Hold for income? Donate to charity? Each has different tax outcomes.
4. Consult Tax Professional: Estate taxation can be complex. A CPA or tax attorney can advise on your specific situation and state-specific rules.
5. Document Everything: Keep records showing the FMV at death (date of death value, estate tax return if filed). You'll need this to prove your basis when you sell.
Summary
Inherited assets receive a "stepped-up basis," meaning your starting tax basis is the asset's value when inherited, not what the deceased paid. This benefit can save hundreds of thousands in capital gains taxes. Understanding this rule helps you make smart decisions about inherited assets: sell immediately for tax-free gain, hold for income, or donate to charity. The stepped-up basis is one of the largest tax benefits available—making inherited assets, from a tax perspective, more valuable than assets you purchase yourself with the same appreciation.