Step-Up in Basis

Step-Up in Basis is a powerful tax provision in the United States that readjusts the value of an appreciated asset for tax purposes upon inheritance. Think of it as a “tax reset button” for your heirs. The rule allows an heir to inherit an asset, like a stock or a house, and have its cost basis “stepped up” to its fair market value at the time of the original owner's death. The cost basis is the original value of an asset for tax purposes, usually the purchase price. By resetting the cost basis to the current market value, the step-up effectively erases all the appreciation—the “capital gain”—that occurred during the original owner's lifetime. This means if the heir decides to sell the asset immediately, there's little to no capital gains tax to pay. This provision is a cornerstone of estate planning in the US, allowing for the incredibly tax-efficient transfer of wealth across generations.

Let's make this crystal clear. Imagine your grandmother, a savvy value investor, bought 100 shares of “Awesome Corp.” back in 1980 for $10 per share. Her total cost basis is $1,000 (100 shares x $10). Decades later, she passes away and leaves these shares to you. By this time, Awesome Corp. has lived up to its name, and the stock is now worth $500 per share. The total value of the holding is $50,000.

• Without step-up in basis: If you inherited her original cost basis of $1,000, selling the shares for $50,000 would create a taxable capital gain of $49,000 ($50,000 - $1,000). You'd owe a hefty tax bill.
• With step-up in basis: The magic happens here. The Internal Revenue Service (IRS) allows the cost basis to be “stepped up” to the $50,000 market value on the date of your grandmother's death. If you sell the shares the next day for $50,000, your capital gain is $0 ($50,000 sale price - $50,000 stepped-up basis). You pay no capital gains tax.

This simple adjustment can save heirs thousands, or even millions, of dollars in taxes.

This isn't just an obscure tax rule; it has profound implications for how you manage your investments, especially over the long term.

For value investors, who often follow a “buy and hold” strategy, the step-up in basis is a massive advantage. It encourages holding onto highly appreciated assets for a lifetime, knowing that the built-up capital gains can be legally wiped away for your beneficiaries. This aligns perfectly with the patient, long-term philosophy of legends like Warren Buffett. Instead of selling a winning stock to rebalance a portfolio and triggering a taxable event, an older investor might choose to hold it, knowing it can be passed on far more tax-efficiently. It also introduces a strategic choice:

• Gifting an asset during your lifetime: If you gift an appreciated stock to your child, they generally receive your original cost basis. This is called a carryover basis. When they sell, they will owe capital gains tax on the full appreciation since you first bought it.
• Bequeathing an asset at death: If they inherit the same stock, they get the stepped-up basis, and the tax liability on that past appreciation vanishes.

Step-up in basis is a central pillar of wealth transfer strategies. It allows families to pass on significant assets—from stock portfolios to family homes and businesses—without the tax burden eroding their value. This makes it a critical topic to discuss with financial advisors and estate planners, as it can influence decisions about which assets to hold and which to sell later in life.

While the “step-up in basis” is a specific US tax concept, similar principles exist in other countries, though the mechanics differ. For example, in the United Kingdom, when a person dies, their assets are revalued for Inheritance Tax (IHT) purposes. The person who inherits the assets acquires them at this revalued market price for their own Capital Gains Tax calculations. So, similar to the US system, the historical capital gain is effectively wiped out. However, the estate itself might be liable for a 40% Inheritance Tax (above a certain threshold), which is a crucial difference. It's a trade-off: you might avoid capital gains tax but face a potentially larger IHT bill. Always consult a local tax professional, as rules vary significantly across Europe.

It's important to know this works both ways. If you inherit an asset that has lost value since the original purchase, the basis is “stepped down” to its current, lower market value. Let's say your grandmother also bought “Dud Corp.” stock for $10,000, but at the time of her death, it's only worth $2,000. Your inherited cost basis becomes $2,000. If you later sell it for $2,500, you have a taxable gain of $500. You cannot claim the original $8,000 loss. In this scenario, it would have been more tax-efficient for your grandmother to sell the losing stock herself, claim the capital loss to offset other gains, and then leave you the cash. This is a key strategic point for investors managing their portfolios in their later years.