Step-Up in Basis: How Real Estate Passes to Heirs

What is step-up in basis? Step-up in basis is the rule, found in Section 1014 of the Internal Revenue Code, that resets the tax basis of property an heir inherits to that property's fair market value on the date of the original owner's death, rather than carrying over whatever basis the deceased owner had. For real estate, that reset can erase years of built-in gain and prior depreciation deductions in a single moment, which is why it sits at the center of so much estate and real estate planning.

Key Takeaways

• Under IRC Section 1014, inherited property generally takes a new basis equal to its fair market value on the date of death, not the decedent's original cost.
• The step-up applies to real estate held directly, but a partnership or LLC interest reported on a Schedule K-1 does not automatically get the same treatment at the entity's own asset level.
• Property given away during life, rather than inherited at death, generally keeps the giver's original basis under a separate carryover rule, with no step-up at all.
• Nine community property states, including Texas, can step up both halves of community property at the first spouse's death rather than only the decedent's half.
• An estate can elect an alternate valuation date six months after death instead of the date of death, but only under specific conditions and only if a federal estate tax return is required.
• Step-up in basis is current federal tax law, but every outcome described here depends on the specific estate, state, and ownership structure involved.

	New basis	Built-in gain at transfer
Lifetime gift to an heir	Carries over from the giver	Carries forward to the recipient
Inheritance, common law state, decedent's half	Stepped up to fair market value at death	Erased
Inheritance, common law state, survivor's own half	No change, stays at original basis	Still present
Inheritance, community property state, both halves	Stepped up to fair market value at death	Erased

Source: 26 U.S.C. § 1014, Legal Information Institute.

What Step-Up in Basis Actually Does

Step-up in basis replaces a decedent's original cost basis in an asset with that asset's fair market value on the date of death, which becomes the heir's new starting point for measuring any future gain or loss. IRS Publication 551, Basis of Assets, states that the basis of property inherited from a decedent is generally the fair market value of the property on the date of the decedent's death.

The practical effect is that whatever gain had built up in the property during the decedent's lifetime simply disappears for tax purposes. In a hypothetical using round numbers chosen for arithmetic rather than drawn from any transaction, an investor who bought a building decades ago for $500,000 and whose heirs inherit it when it is worth $3,000,000 passes that property to the heirs with a new basis of $3,000,000. If the heirs sell shortly after for close to that value, there is little or no taxable gain to report, even though the original owner was carrying $2,500,000 of unrealized appreciation.

One statutory exception is worth flagging. Publication 551 notes that the step-up does not apply to appreciated property an heir had given to the decedent within one year before the decedent's death. In that narrow circumstance, the heir's basis reverts to the decedent's adjusted basis immediately before death rather than resetting to fair market value, which is a rule aimed at preventing a quick round trip designed purely to capture the step-up.

Why This Matters More for Real Estate Than for Most Other Assets

Real estate carries two layers of built-in tax exposure that step-up in basis addresses at once: the appreciation in the property's value, and the depreciation deductions already claimed against it. Both layers reset together at death, which is part of why long-held, heavily depreciated commercial property is discussed so often in this context.

During ownership, depreciation reduces an owner's basis year after year, and that reduction is what produces depreciation recapture if the property is sold during the owner's lifetime. The mechanics of that recapture, including the different rates that apply to different components of a building, are covered in the guide to depreciation recapture at sale. Because step-up resets basis to fair market value at death rather than carrying forward the reduced, depreciated basis, an heir who inherits the property and sells it soon after generally has no recapture to report on the decedent's prior depreciation, since the basis that recapture would have been measured against no longer exists.

This is also why a property owner who keeps deferring gain through a Section 1031 exchange, sometimes described informally as swapping until death, can end that chain of deferral entirely at death rather than passing it forward. The mechanics of how that deferral works during life are set out in the guide to the tax benefits of commercial real estate. None of this changes anything about the property's economics or its ongoing depreciation schedule going forward for the heir, who starts a fresh depreciation schedule on the new, stepped-up basis.

Gifted Property vs. Inherited Property: Two Different Basis Rules

Property given away during a person's lifetime follows a different and generally less favorable basis rule than property passed down at death. Under the carryover basis rule in Section 1015 of the Internal Revenue Code, a gift recipient generally takes the same basis the giver had, plus any gift tax paid that is attributable to the appreciation, rather than resetting to the property's current fair market value.

The contrast is direct. A parent who gifts an appreciated rental property to a child during life passes along the parent's original, lower basis, and the built-in gain travels with the property to be realized whenever the child eventually sells. The same parent who instead holds the property until death and lets it pass through an estate or a trust generally passes it with a stepped-up basis equal to its value at death, erasing that built-in gain for the recipient.

There is a second wrinkle for a gift of property that has actually declined in value. If the fair market value at the time of the gift is lower than the giver's basis, the basis used for determining a loss is the lower fair market value at the time of the gift, which creates a dual-basis rule depending on whether the eventual sale produces a gain or a loss. None of this is a reason to make or avoid a particular gift on its own. It is a reason to know which rule applies before deciding how and when to transfer a specific property, which is a decision that depends on the donor's full estate picture and belongs with an estate planning attorney and a tax advisor together.

How Step-Up Reaches a Property Held Through an LLC or Partnership

An interest in a partnership or an LLC taxed as a partnership, including an interest in a real estate fund reported on a Schedule K-1, is itself property for purposes of Section 1014, so an heir's outside basis in that interest generally steps up to its fair market value at death. What does not automatically step up is the partnership's own inside basis in the specific properties it owns, and that mismatch is the detail investors holding fund interests most often miss.

Inside basis and outside basis are two separate numbers tracked for different purposes, a distinction covered in more detail in the guide to reading a Schedule K-1 from a real estate fund. The heir's outside basis in the partnership interest resets under Section 1014 regardless of what the partnership does. The partnership's inside basis in its buildings, which drives the depreciation deductions allocated out to partners each year, only adjusts for that specific heir if the partnership has a Section 754 election in effect, which then triggers a Section 743(b) basis adjustment attributable solely to the transferee's share.

Without that election in place, an heir can end up with an outside basis that reflects current fair market value while still being allocated depreciation and gain calculated against the partnership's old, unadjusted inside basis, a mismatch that can produce taxable income on a later sale that feels disconnected from the economics the heir actually experienced. Whether a given partnership has made, or should make, a Section 754 election is a decision for the entity and its tax advisors, and whether it matters for a specific inherited interest depends on the partnership's own facts.

Community Property States: A Step-Up on Both Halves

In the nine community property states, Section 1014(b)(6) can step up both halves of community property to fair market value when the first spouse dies, not only the half that belonged to the decedent, provided at least half the community interest is includible in the decedent's gross estate. In the remaining common law states, only the decedent's half of jointly owned property generally receives the step-up, while the surviving spouse's own half keeps its original basis.

Texas is one of the nine community property states, alongside California, Arizona, Nevada, New Mexico, Washington, Wisconsin, Idaho, and Louisiana. For a married couple holding real estate as community property in one of those states, the practical effect at the first spouse's death is that the surviving spouse's basis in the entire asset, not just the decedent's share, can reset to current fair market value, which removes built-in gain on the survivor's own half as well as the decedent's.

Whether a specific asset actually qualifies as community property, rather than separate property, depends on how and when it was acquired and how it has been titled and commingled over the years, which is a factual determination for an estate planning attorney familiar with the applicable state's community property rules rather than something to assume from the state of residence alone.

The Alternate Valuation Date

An estate's executor can elect to value estate property as of six months after the date of death instead of the date of death itself, a choice governed by Section 2032 of the Internal Revenue Code and known as the alternate valuation date. The election is only available when a federal estate tax return is required to be filed in the first place, and it is only permitted if using it decreases both the total value of the gross estate and the amount of estate tax owed.

The election is also all or nothing. An executor cannot pick alternate valuation for some assets and date-of-death valuation for others; the choice applies across the entire estate once made, as described in the Instructions for Form 706. For real estate specifically, that means an executor weighing whether to use the alternate date is weighing the effect across every asset in the estate at once, not just the one building that may have lost value in the six months after death.

Every determination described in this guide, including whether a particular transfer qualifies for step-up, whether a Section 754 election applies to a specific partnership interest, whether a given asset is community property, and whether an alternate valuation election would help a particular estate, depends on facts specific to the decedent, the heirs, and the state involved. Freedom Commercial Real Estate does not provide tax or legal advice, and nothing in this guide should be read as such. These questions belong with your own CPA, tax advisor, and estate planning attorney.

Freedom Commercial Real Estate publishes guides like this one so investors and their families can understand how basis rules actually work before an estate plan is drafted or a property changes hands. Questions about anything covered here, or a topic worth explaining next, can go straight to the team at info@freedomcre.net.

Frequently Asked Questions

Q: Does step-up in basis apply to a rental property I bought myself?

A: No. Step-up in basis under Section 1014 applies to property acquired from a decedent, meaning property an heir receives when the owner dies. A property you purchased and still own is not affected by this rule at all, and your basis continues to be determined by what you paid, adjusted for improvements and depreciation, until you eventually sell it or pass it on yourself.

Q: Is it better to gift real estate to my children now or leave it to them when I die?

A: A lifetime gift generally carries over the giver's original basis under Section 1015, while property left at death generally gets a step-up to fair market value under Section 1014, which can mean a materially different tax result for the recipient depending on how much the property has appreciated. Which approach fits a specific family's situation depends on the full estate picture, including other assets, state law, and goals beyond taxes, and is a question for an estate planning attorney and a tax advisor working together rather than a general rule.

Q: Does my K-1 fund interest get a step-up in basis when I die?

A: Your outside basis in the partnership interest itself generally steps up to fair market value under Section 1014, regardless of what the fund does. The partnership's own inside basis in its properties, which drives the depreciation and gain allocated to your heirs afterward, only adjusts to match if the partnership has a Section 754 election in effect. Whether that election exists, and whether it matters for your specific interest, is a question for your tax advisor and the fund's own tax preparer.

Q: Do all states treat inherited property the same way for basis purposes?

A: The federal step-up rule under Section 1014 applies nationwide, but community property states can produce a different result for married couples. In the nine community property states, including Texas, both halves of community property can step up at the first spouse's death, while in common law states only the decedent's half generally steps up and the survivor's half keeps its original basis. Whether a specific asset qualifies as community property is a factual question for an estate planning attorney in that state.

Sources

• Internal Revenue Service, Publication 551: Basis of Assets
• 26 U.S.C. § 1014, Basis of Property Acquired From a Decedent, Legal Information Institute
• Internal Revenue Service, Instructions for Form 706 (alternate valuation)

This article is for informational purposes only and is not an offer to sell or a solicitation of an offer to buy any security, nor investment, tax, or legal advice. Any offering is made only through official offering documents to verified accredited investors. Past performance does not guarantee future results.