The Stepped-Up Basis Rules Are More Important Than Ever in Estate Planning

Because of recent tax law changes, income taxes — not estate taxes — are now a more significant focus in estate planning. And one key planning area is the step-up in basis, which affects the capital gains tax heirs owe when they sell inherited assets.

Why Income Taxes Are a Focus

The 2026 federal gift and estate tax exemption is $15 million (twice that on a combined basis for married couples). It had been scheduled to revert back to approximately half that amount this year, but the One Big Beautiful Bill Act made the higher exemption permanent. This just means there's no expiration date for the higher exemption; lawmakers could still reduce it in the future.

Nevertheless, as long as the higher exemption is in place, only the wealthiest families will be exposed to federal gift or estate tax liability. As a result, most taxpayers are more concerned with the income tax impact of estate planning than the gift and estate tax impact.

How Capital Gains Are Taxed

Normally, when assets such as securities are sold, any resulting gain is taxable capital gain. If the assets have been owned for one year or less, this is a short-term capital gain that's taxed at the taxpayer's ordinary income tax rate, which may be as high as 37%.

Conversely, if the assets have been held for more than one year, it's a long-term capital gain that's taxed at a lower rate. The long-term capital gains rate is typically 15%, but it increases to 20% for certain higher-income individuals. This rate kicks in at lower income levels than the top ordinary-income rate does. In addition, the 3.8% net investment income tax (NIIT) may apply to gains of higher-income taxpayers — even those with a long-term gains rate of 15%.

A 0% long-term capital gains rate generally applies to long-term gains that would be taxed at 10% or 12% based on the taxpayer's ordinary-income rate. But the 0% rate applies only to the extent that capital gains "fill up" the gap between the taxpayer's taxable income and the top end of the 0% bracket.

Gains and losses are netted against each other when filing a tax return. So gains may be offset wholly or partially by losses. The amount of a taxable gain is equal to the difference between the taxpayer's basis in the asset and the sale price. For example, if you acquire stock for $1,000 and then sell it for $3,000, your taxable capital gain is $2,000.

How the Step-Up in Basis Works

When assets are passed to the younger generation through inheritance, there generally are no income tax consequences until the assets are sold. For these purposes, the basis for calculating gain is "stepped up" to the assets' value on the deceased's date of death. Thus, only appreciation in value after the individual inherited the assets is subject to tax. Appreciation during the deceased's lifetime is untaxed.

Assets affected by the stepped-up basis rules include securities, business interests, real estate and personal property. However, these rules don't apply to retirement assets such as 401(k) plans or IRAs.

To illustrate the benefits, let's look at a simplified example. Carol bought stock 15 years ago for $10,000. In her will, she leaves the shares to her son, Jason. When Carol dies, the stock is worth $100,000, so Jason's basis is stepped up to $100,000.

When Jason sells the stock one year later, it's worth $110,000. Let's say Jason's income is high enough that he must pay the maximum 20% long-term capital gains rate plus the 3.8% NIIT on his gain. Jason has a $10,000 gain that's taxed at 23.8%. Therefore, he owes $2,380 in taxes. Without the stepped-up basis, his gain would have been $100,000, and his tax would have been $23,800.

What happens if an asset is worth less on the date of death than when the deceased acquired it? The adjusted basis of the inherited asset would still be the value on the deceased's date of death. This would be a basis step-down. It could result in a taxable gain on a subsequent sale if the value rebounds after death or a loss if the value continues to decline.

Planning for the Step-Up

One way to reduce estate tax liability is to make lifetime gifts to family members. Under the gift tax annual exclusion, you can give each recipient gifts valued up to $19,000 in 2026 gift-tax free ($38,000 per recipient for joint gifts by a married couple) without using up any of your lifetime exemption.

As with inherited assets, there generally are no income tax consequences for a gift recipient until the assets are sold. But the basis step-up doesn't apply to lifetime gifts. If you give appreciated assets to a family member, your basis carries over to the recipient. Being strategic about which assets you gift during your life and which ones you bequeath after death can save taxes for your family overall.

For example, Kevin and Melissa don't expect their estates to be large enough for federal estate taxes to be a concern — they're focused on the income tax aspects of estate planning. They want to give their daughter, Emma, $30,000 of stock so she can sell it and put the proceeds toward a down payment on her first home. They can give her either $30,000 of stock that they paid $5,000 for 10 years ago or $30,000 of a different stock that they paid $25,000 for two years ago. Based on Emma's income, she'll be subject to the 15% long-term capital gains rate but not the NIIT when she sells the stock.

If Kevin and Melissa give her the stock with the $5,000 basis and Emma sells it immediately, she'll have a gain of $25,000 and owe $3,750 in taxes. If they give her the stock with the $25,000 basis and Emma sells it immediately, she'll have a gain of $5,000 and owe $750 in taxes. That's clearly the more tax-efficient option in the short term.

Now imagine that Kevin and Melissa hold the $5,000-basis stock until their deaths, when they bequeath it to Emma. Let's say the stock is worth $75,000 when she inherits it, and that her income is high enough by then to be subject to the 20% long-term capital gains rate and the 3.8% NIIT on any gain she realizes.

Because of the step-up, her basis will be $75,000. So, if she immediately sells the stock, she'll recognize no gain and owe $0 taxes on the $70,000 of appreciation. Without the basis step-up, she'd owe $16,660 in taxes. That's how valuable stepped-up basis can be.

However, there are many factors to consider. If, around the time that Kevin and Melissa wanted to make the $30,000 gift to Emma, they also wanted to divest themselves of the $5,000-basis stock (because its future prospects looked dim or they simply wanted to diversify), giving it to Emma could have made tax sense. This might have been the case if:

• Kevin and Melissa would have been subject to the 20% long-term capital gains rate and the 3.8% NIIT if they sold it, because Emma would pay tax at a lower 15% rate and no NIIT, or
• Kevin and Melissa would have been subject to the 15% rate, and Emma's income had been low enough that she would have been subject to the 0% long-term rate on some or all of the gain.

As you can see, tax-smart planning that accounts for the various tax rates, basis differences within a portfolio and stepped-up basis rules gets complicated quickly. Things get even more complex if you're on the cusp of having an estate that's large enough for federal estate taxes to be a concern.

Achieving Your Estate Planning Goals

Tax saving is only one estate planning goal. You also want to ensure that your loved ones are provided for as you wish and that you can leave your desired legacy, such as supporting a favorite charity or preserving a family business.

Your tax and estate planning advisors can help you assess your family's tax situation and develop an estate plan that fits your goals — or update your existing plan as needed in light of tax law, financial or family changes.