According to the Internal Revenue Code, when a beneficiary receives an asset from a benefactor after the individual passes away, that asset typically receives a stepped-up basis.  This is the market value of the asset at the time the benefactor passes away.  The stepped-up basis is typically much higher than the assessed cost basis before the individual passed away, which is generally the purchase price the individual originally paid for the asset.  As capital-gain taxable income is based on the selling price less the basis, a large stepped-up basis will greatly decrease the beneficiary’s capital-gain taxable income when the beneficiary decides to sell the inherited asset.

Capital Gains Tax

Capital gains tax starts with your basis in any asset, which is the amount you originally paid for the asset.  In addition, in some cases the basis can also include the cost of any capital improvements you have made on the property.  You then pay capital gains tax on the difference between the price you sell the asset for and your basis in the property.  Obviously, it is also possible to experience a capital loss if the selling price is lower than your basis.

What exactly is the stepped-up basis loophole?

Essentially, under the current American tax laws, any qualified stocks, real estate, as well as other capital assets that you leave to your beneficiaries after you pass away have their original fair market value erased completely.  What this boils down to is that your beneficiaries can value any property inherited from your estate at its fair market value as of the date they actually inherited the asset.

General Rule of Stepped-Up Basis

Internal Revenue Code 1014(a) applies to any assets a beneficiary inherits after the benefactor passes away.  The general rule, according to this code, is that the beneficiary’s basis is equal to the fair market value of the asset at the point in time the benefactor passes away.  This can result in either a stepped-up or a stepped-down basis.


The basis is typically the amount of money you have invested in an asset.  So, if you buy a house for $50,000, you basis is also $50,000.

In simplified terms, the gain is the amount of money you receive when you sell the asset less your basis in the asset.  Therefore, if you sell the house for $125,000, your capital gain would be $75,000.  (Please understand that this is actually a very simplified example.  There are many complicating factors that occur in real life examples.)

Now, let’s say that your parents decide to give you this house before they pass away.  In this case, your basis for the house would also be $50,000 – the same basis your parents have in the asset.  It does not matter what the current fair market value of the house actually is.  If you now sell the house for $125,000 your taxable capital gain income is $75,000.

However, if your parents leave the house to you in their will, the story is quite different.  In this case, your basis in the asset is actually stepped up to the current fair market value of the house.  Therefore, if the current fair market value is $100,000 and you sell the home for $100,000 you have accumulated no capital gain taxable income.  Quite a benefit over the previous scenario, isn’t it?

The Result is a Strong Incentive for Taxpayers

Due to this provision included in the Internal Revenue Code, any property that appreciated during the deceased’s lifetime will actually never be taxed.  Consequently, the code gives a strong incentive for taxpayers to keep any appreciated property until they pass away, and sell any other property that has decreased in market value while they are still alive.

Important Points to Remember

The stepped-up basis readjusts the value of any appreciated asset over a period of time for tax purposes.

The stepped-up basis is used to calculate any possible tax liabilities of assets inherited after a loved one passes away.