All About the Stepped-Up Basis Loophole

A stepped-up basis changes the taxable value of inherited property by resetting it to the asset’s fair market value at the time the previous owner dies. When the beneficiary eventually sells, any taxable gain is calculated from this updated value rather than the original purchase price. This approach often reduces the taxable portion of appreciation and can influence how heirs think about managing, keeping or liquidating inherited assets.

Consider working with a financial advisor to help you come up with a plan to reduce your overall investment taxes.

What Is the Stepped-Up Basis?

The stepped-up basis (sometimes known as the step-up cost basis) is a way of adjusting the capital gains tax. It applies to investment assets passed on in death.

When someone inherits capital assets such as stocks, mutual funds, bonds, real estate and other investment property, the IRS “steps up” the cost basis of those properties. This means that for the purpose of capital gains tax, the IRS sets the cost basis of any given investment asset to its value when the asset is inherited. When the heir sells this asset, they only pay money on profits calculated from the day they inherited it.

The result of the stepped-up basis loophole is that heirs save significant money on investment assets that they inherit. Moreover, this legal loophole is crucial for estate planning. When individuals prepare their wills and trusts, they can minimize how much the IRS takes by handing down securities rather than cash.

Example of the Stepped-Up Basis Loophole

Let’s say you own 10,000 shares of ABC Co. stock. You bought those shares at $20, leading to an original cost basis of $200,000. You are drafting your will and you want to hand this stock down to your son. At this time, ABC Co. is valued at $30 per share. You likely have two options, outlined below.

Option A: Cash Transfer

For simplicity’s sake, let’s ignore any other tax issues. You sell your shares in ABC Co. Your proceeds are $300,000 and your profits are $100,000. Assume you would pay a standard 15% capital gains tax on this transaction, coming to $15,000. As a result, you pass $285,000 down to your son.

Option B: Stock Transfer

Instead of selling your stock, you hand your shares of ABC Co. down to your son entirely. When you die, ABC Co. is still worth $30 per share. Your son inherits all 10,000 shares and sells them immediately upon receipt.

At the time your son inherits these shares, the IRS resets their tax basis to $30. Your son sells these shares for $300,000. He doesn’t owe any taxes on this sale because, as far as the IRS is concerned, he didn’t make a profit off this sale.

The stepped-up basis loophole allows someone to pass down assets without triggering a tax event, which can save estates considerable money. It does, however, come with an element of risk. If the value of this asset declines, the estate might lose more money to the market than the IRS would take. However, keeping that in mind, the stepped-up basis is still an important part of estate tax planning.

How Do Capital Gains Taxes Work?

Capital gains are a special, generally lower, category of taxes imposed at the time a security is sold and based on the amount by which that security has gained value. So, for example, if you sell a stock, the money that you earn off that it triggers capital gains taxes.

This is different from income taxes, which are generally imposed on money earned from salary and wages. Put another way, income tax typically applies to labor, while capital gains tax applies to profits from investments. However, some non-labor income, such as rental income or bond interest, is also taxed as ordinary income.

Use our income tax calculator to understand how your income translates into what you may owe.

The capital gains tax applies only to the profits by selling assets. The value of the asset when you first bought or acquired it is called its “original cost basis.” The IRS then calculates your profits by subtracting the proceeds of the sale from the asset’s original cost basis. Capital gains taxes are then applied to those profits.

The agency also taxes short- and long-term capital gains differently. Short-term capital gains, which come from investments sold under one year, are taxed as ordinary income. Conversely, long-term capital gains, which come from investments held over a year, are taxed at a lower rate. The table below breaks down current long-term federal capital gains tax rates:

2026 Federal Long-Term Capital Gains Tax Rates

2025 Federal Long-Term Capital Gains Tax

Example of a Capital Gains Tax Calculation

Let’s say you own 1,000 shares of stock in ABC Inc. When you bought the shares, they were valued at $20 per share, leading to a purchase price, or original cost basis, of $20,000. A few years later, you sell your investment in ABC Co. When you sell the shares, they are worth $35 each. As a result, you now get $35,000 from the sale, which are the proceeds.

You would pay capital gains taxes on your profits from the sale, and your income bracket makes your tax rate 15%. As a result, you may pay the following in taxes:

• Proceeds – Original Cost Basis = Profit
  • Robert’s scenario: $35,000 in proceeds – $20,000 in original cost basis = $15,000 in profits
• Long-Term Capital Gains Rate x Profit = Capital Gains Tax Owed
  • 15% capital gains rate x $15,000 in profit = $2,250 in capital gains taxes

Based on the above, you would owe $2,250 in federal taxes on your sale. This is significantly more preferable than if his capital gains were short-term in nature.

Step-Up Basis in Community Property States

Residents of nine different community property states can take advantage of a double step-up basis tax rule. This allows a step-up basis on all community property for the surviving spouse. Community property means any asset that was accumulated during the marriage with the exception of any gift or inheritance.

In many other states, neither assets that are only owned by the surviving spouse or jointly owned assets do not get the same treatment. The assets of a surviving spouse don’t get any step-up basis and jointly owned assets only get half of the basis. However, a surviving spouse can obtain the step-up basis on anything that is inherited from the deceased in any state.

Bottom Line

A stepped-up basis is a tax law that applies to estate transfers. When someone inherits investment assets, the IRS resets the asset’s original cost basis to its value at the date of the inheritance. The heir then pays capital gains taxes on that basis. The result is a loophole in tax law that reduces or even eliminates capital gains tax on the sale of these inherited assets.

Tax Planning Tips

• A financial advisor can help you establish a plan to minimize potential taxes. Finding an advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• The stepped-up basis loophole is just one thing to keep in mind when planning an estate. Another key topic is estate taxes. Further, it’s important to understand how estate planning differs from legacy planning.

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