Basis Step-Up Strategies for Estate Planning

Basis step-up simplified

Here’s a straightforward example of how this rule works in practice.

Say an individual owns company shares now worth $100,000 on the open market. That’s their fair market value (FMV). They originally bought that stock for just $10,000, which is their “cost basis.” If they sell today, they may owe capital gains tax on the $90,000 difference between the sale price and their original basis.

Now consider a different outcome: rather than selling, they hold the stock for the rest of their life and leave it to their child as an inheritance. Under Internal Revenue Code (IRC) Section 1014(a), the child may inherit the stock with a new “stepped-up” basis equal to the $100,000 FMV as of the date of the parent’s passing.

When the child later sells the stock at that same $100,000 FMV, the taxable gain may be zero because the sale price and the stepped-up basis are equal. The original $90,000 in built-in gains effectively disappears for tax purposes.

When basis step-up applies

Here’s the key rule to remember: with very few exceptions, an asset may receive a basis step-up only if it is subject to estate tax.¹ Think of it as the lollipop after the estate tax shot — the two go hand in hand. If an asset wasn’t subject to estate tax, it generally won’t receive a basis step-up either. No shot, no lollipop.

There is one nuance worth noting: an asset doesn’t have to generate an actual estate tax bill to qualify. It simply needs to be included in the decedent’s gross estate which means it was subject to estate tax as part of the calculation. Even if an estate falls entirely below the lifetime exemption amount and owes zero in estate tax, its assets may still receive a full basis step-up.

Determining fair market value

The stepped-up basis is set at the asset’s “fair market value” on the date of the decedent’s death. That’s the IRS standard under Code Section 1014(a)(1). What the Code doesn’t spell out, however, is exactly how to calculate that value for every type of asset. Fortunately, the IRS and Treasury regulations provide guidance for common asset classes.

For other asset types, the standards vary:

• Cash values can fluctuate and may require a formal valuation in certain circumstances.
• Everyday personal property (vehicles, clothing, household items) may generally be valued using a reasonable good faith estimate.
• Artwork, collectibles, and antiques may require a specialized appraisal given the complexity and potential value involved.
• Real estate must generally be supported by a formal appraisal from a licensed appraiser. A comparative market analysis or agent estimate may not hold up in an audit. If you’ve recently inherited a home, you may also want to review the financial and tax considerations that come with inheriting a house.
• Closely held businesses and nontraded securities always require a formal valuation from a qualified CPA or business valuation specialist.

In short, while the Code doesn’t mandate a formal appraisal in every case, obtaining one is often the safest course — both for accuracy and for defensibility if the IRS ever takes a closer look.

Full basis step-up for community property

Where you live, and how you hold title to your assets, can significantly affect how the basis step-up rule applies to your estate.

Community property is a form of joint ownership available to married couples in certain states.² In these states, assets acquired during marriage are generally owned 50/50 by both spouses. The basis step-up rules work quite differently here than they do in the rest of the country.

In common law states (states that don’t recognize community property), each spouse may own assets separately or jointly. At the first spouse’s death, a basis step-up may apply to:

• 100% of the deceased spouse’s separate property, and
• 50% of any jointly owned property (since each spouse is deemed to own half).

In community property states, a special rule under Code Section 1014(b)(6) may provide a 100% basis step-up on the entire community property asset, not just the deceased spouse’s half.³ That means the surviving spouse’s share may also receive a stepped-up basis, a significant advantage that common law states don’t offer.

For this full step-up to apply, at least 50% of the community property must be included in the deceased spouse’s gross estate — a threshold that is almost always met, since each spouse is deemed to own 50% by default.

Basis step-up for trust-owned property

So far, we’ve looked at assets owned directly by individuals. But in the estate planning world, it’s just as common for assets to be held inside trusts. So how does the basis step-up rule apply to an entity, like a trust, that never actually dies?

The answer is the same as always: it comes down to estate inclusion. Whether an asset earns a basis step-up depends entirely on whether it was included in someone’s gross estate at death.

Revocable trusts are straightforward. When a grantor creates and funds a revocable trust, the trust isn’t treated as a separate taxpayer. Its assets and income are reported under the grantor’s Social Security number, and the grantor retains full ownership for tax purposes, including for estate tax calculation.⁴ Because those assets are included in the grantor’s gross estate at death, they generally receive a basis step-up.

Irrevocable trusts are a different story. When a grantor transfers assets into an irrevocable trust — such as a Spousal Lifetime Access Trust (SLAT) or an Irrevocable Life Insurance Trust (ILIT) — they give up sufficient use and control of those assets that they no longer fall within the Code’s definition of the grantor’s gross estate.⁵ Because those assets are outside the estate, they generally won’t receive a basis step-up. No shot, no lollipop.

Here’s the key takeaway: you can’t simply look at whether a trust is labeled “revocable” or “irrevocable” to determine the answer. You need to read the trust itself. Certain irrevocable trust structures, and specific provisions within them, can cause assets to be pulled back into the grantor’s gross estate, or even into the estate of a future beneficiary. Each situation is unique, which is why a thorough review by an estate planning professional is always advisable before drawing conclusions about basis step-up treatment for irrevocable trusts.

Next steps

The basis step-up rule is a powerful planning tool — but it’s not one-size-fits-all. Every estate is different, and whether a specific asset qualifies for a step-up depends on how it’s owned, how it’s structured, and how it fits into your broader long-term estate planning picture.

When you’re a client of Mercer Advisors, our dedicated estate planning team collaborates directly with your advisor (or with your outside attorney) to help you navigate these questions with clarity and confidence.