Understanding Cost Basis and Taxes When Inheriting Assets
When a loved one passes away, it can be an overwhelming and emotional time, filled with grief, uncertainty, and a lot of questions about what comes next. Among the many concerns that may arise, one of the most frequently heard is: “What will this mean for my taxes on the assets I’ve inherited?” The idea of navigating taxes and financial matters while processing your loss can feel daunting. Fortunately, understanding how the cost basis of inherited assets works can help ease some of that burden, ensuring you’re not faced with unexpected tax bills when the time comes to manage or sell those assets.
Let’s take a deep dive into what happens to the cost basis of various assets when you inherit them and why understanding this can make a big difference in your tax situation. We’ll also discuss how considering the cost basis and the types of assets in your estate planning is crucial for your heirs to minimize future taxes.
What Is Cost Basis?
The cost basis of an asset is essentially what you paid for it. For stocks or real estate, it’s the original purchase price, plus any associated costs (like commissions or improvements). The IRS uses this figure to determine how much you’ve gained or lost when you sell that asset, which directly impacts your tax obligation.
Step-Up in Basis When Inheriting Assets
The rules for inherited assets are much different from assets you sell yourself. When you inherit most types of assets, the IRS typically provides a “step-up in basis“. This means that the cost basis of the asset is adjusted to its fair market value (FMV) as of the date of the decedent’s death, rather than the amount the original owner paid for it.
For example, let’s say your parent bought a stock 20 years ago for $10 per share, but it’s worth $50 per share when they pass away. If you inherit the stock, your cost basis for that asset becomes $50 per share, not $10. If you sell it for $55 per share, you will only pay capital gains taxes on the $5 difference, not the $45 that would have been taxable if you inherited it at the lower $10 per share price.
The step-up in basis significantly reduces the amount of capital gains tax you could owe if you decide to sell the asset soon after inheriting it. This can be especially beneficial for individuals who inherit appreciated assets, such as stocks, real estate, and other investments.
However, several important caveats and nuances must be taken into account.
What Happens to the Cost Basis of Different Assets?
- Stocks and Bonds:
- As mentioned, most stocks and bonds you inherit will have their cost basis stepped up to the market value at the date of death. If you sell them right away, you’ll likely pay little to no taxes.
- Real Estate:
- The step-up in basis applies to real estate as well. If your parents bought a house for $200,000 and it’s worth $500,000 when they pass away, your cost basis on the house becomes $500,000. This can save you from paying capital gains tax on the $300,000 increase in value that occurred over the years.
- Exception: If the real estate is part of a rental property or an investment property, there may be depreciation recapture, which could affect the taxes owed. This is something to consider if you’re inheriting a rental property.
- Retirement Accounts (IRAs, 401(k)s, etc.):
- The situation with retirement accounts is a bit different. These accounts don’t benefit from the step-up in basis because they are tax-deferred. When you inherit an IRA or 401(k), you will need to pay income tax on any distributions you take from these accounts.
- However, the step-up in basis rule doesn’t apply to the underlying assets within the account, meaning if the retirement account holds stocks or bonds, the appreciation within that account isn’t subject to capital gains taxes when you inherit it, but it will be taxable when you withdraw the funds.
- Life Insurance
Life insurance proceeds paid out upon the death of the insured are generally not subject to capital gains tax, so the step-up in basis rules do not apply. This is because the death benefit is typically received income-tax-free by the beneficiary, and there’s no underlying asset with a cost basis that would need adjustment. However, if a life insurance policy is sold or transferred for value before the insured’s death, the rules become more complex. Any gain on the policy may be taxable, but it is not subject to a step-up in basis, as it’s not considered a capital asset in the traditional sense.
Additionally, who owns the policy is also important. If the insured is also the owner at death, the proceeds may be included in their taxable estate, potentially triggering estate taxes. In contrast, ownership by an irrevocable life insurance trust (ILIT) can help keep the death benefit outside the estate.
- Annuities and Step-Up in Basis:
Annuities do not receive a step-up in basis at the owner’s death. The earnings (or growth) within a non-qualified annuity (one funded with after-tax dollars) remain taxable as ordinary income to the beneficiary when distributions are taken. The beneficiary inherits the contract with the original owner’s cost basis, and withdrawals are taxed on a last-in, first-out (LIFO) basis, meaning that gains are taxed first.
In contrast, qualified annuities, which are held within tax-deferred retirement accounts like IRAs or 401(k)s, are fully taxable as ordinary income upon distribution, since no taxes were paid on the contributions or growth. In both cases, annuities are not eligible for a step-up in basis, and unlike capital assets such as stocks or real estate, they pass on with their original tax treatment intact.
- Collectibles (Art, Jewelry, etc.):
- Items such as art, rare collectibles, or jewelry may not always see a full step-up in basis if they have appreciated value. However, many of these items are exempt from the usual capital gains tax rules if you sell them, depending on your specific jurisdiction and the nature of the asset.
- Business Interests:
- If you inherit a business (whether it’s an LLC, corporation, or partnership), the assets that make up the business may receive a step-up in basis. This can be particularly important for family-owned businesses, as it may minimize any capital gains taxes if the business is sold later.
What About the Estate Tax?
While a step-up in basis significantly lowers your potential capital gains tax, you may still have to consider estate taxes. If the estate of the decedent is particularly large, estate taxes may apply to the overall estate value. However, most estates do not exceed the federal estate tax exemption threshold.
The passage of the One Big Beautiful Bill (OBBB) increased the exemption amount to $15 million per individual as of 2025. The estate will be responsible for paying these taxes before distributing the assets to the beneficiaries.
Planning Your Estate: A Step-Up in Basis Could Be Key
As someone who may inherit assets in the future, it’s not only essential to understand how the step-up in basis works, but also how you can use it to your advantage when planning your own estate.
- Asset Selection Matters:
When planning your estate, consider which types of assets you would like to pass down to your heirs. Assets that appreciate over time, such as stocks, real estate, and businesses, can benefit from the step-up in basis, which reduces your heirs’ potential capital gains tax burden. On the other hand, assets that are taxed on their earnings (like retirement accounts) may not benefit from this step-up, so it’s important to plan how to allocate these different types of assets.
- Tax Efficiency:
The step-up in basis is a key reason why certain assets, such as a home or stocks, may be better passed down to heirs than sold during your lifetime. By leaving highly appreciated assets to your heirs, you can potentially avoid capital gains taxes altogether. It’s essential to work with your financial advisor, estate attorney, and tax professional to make sure your estate plan is tax-efficient and designed to take full advantage of this rule. At Waterworth Wealth Advisors, LLC, we collaborate with both your CPA and estate attorney to create a custom estate and tax planning strategy.
- Consider Each Heir’s Situation:
If you have multiple heirs, you may want to consider how the assets will impact their individual tax situations. Some heirs may benefit from the step-up in basis more than others, depending on their income and tax rates. You may also want to consider setting up trusts or other mechanisms to ensure assets are distributed in the most tax-efficient way.
- Regular Estate Planning Reviews:
Tax laws change frequently, and it’s crucial to review your estate plan periodically. The recent passage of the One Big Beautiful Bill Act made changes to the estate tax exemption and several other areas.
It’s crucial to ensure your plan continues to take advantage of current tax laws, including any changes to estate or capital gains taxes. If you are unsure how the latest legislation may have impacted you, please schedule a meeting so we can review your unique situation.
Conclusion
Inheriting assets can be an emotional and complex process, but understanding the concept of cost basis and how the step-up in basis works can help relieve some of the uncertainty. The step-up in basis is a powerful tool that can save you from paying significant capital gains taxes on inherited investments, real estate, and other appreciated assets.
When planning your own estate, it’s important to consider not only the assets you want to leave as a legacy but also the tax implications for your heirs. A well-structured estate plan, with careful consideration of the step-up in basis rules, can help maximize your heirs’ financial security and minimize their tax burdens.
By working with financial and legal professionals, such as Waterworth Wealth Advisors, LLC, you can protect your legacy and provide for your loved ones in the most tax-efficient manner possible.
