A note before we begin: A note before we begin: I’m a real estate agent, not an attorney or tax professional. This article is intended for informational purposes only and should not be taken as legal or tax advice. Every situation is different — please consult a qualified attorney or tax advisor before making any decisions. Much of the information here draws on resources from First American Exchange Company, specialists in 1031 exchanges. If you’re considering an exchange, I’d be happy to connect you with them or another qualified exchange facilitator. My role is to handle everything on the real estate side — finding the right properties, negotiating, and managing the transaction. The facilitator handles the exchange itself, which is a legal requirement. Think of us as a team working together on your behalf.
What Is a Step-Up in Basis?
When you inherit property, U.S. tax law resets the cost basis of that asset to its fair market value on the date of the original owner’s death. This reset is called the step-up in basis — and it is one of the most powerful tax advantages available to heirs.
Any appreciation that occurred during the decedent’s lifetime is effectively wiped clean. If your parent bought a home in 1985 for $90,000 and it’s worth $1.2 million at the time of their death, you inherit it with a basis of $1.2 million. Sell it for that amount, and you owe no capital gains tax on the $1.11 million of appreciation that happened before you ever owned it.
“The step-up in basis can erase decades of capital gains in a single moment — one of the most significant tax advantages the U.S. code offers to heirs.”
Understanding Cost Basis
Before we go further, it helps to understand what cost basis means in plain terms. Your cost basis in a property is generally what you paid for it, plus the cost of any improvements you made over the years, minus any depreciation you’ve claimed.
When you eventually sell an asset, capital gains tax is calculated on the difference between your sale price and your cost basis. A low basis relative to today’s value means a large taxable gain. A basis that has been stepped up to current market value means little or no taxable gain — at least at the moment of inheritance.
This is why the step-up matters so much: it resets the starting line for capital gains calculations, often eliminating a tax bill that could otherwise run into the hundreds of thousands of dollars.
Why Fair Market Value Matters
The stepped-up basis is set at the property’s fair market value (FMV) on the date of the decedent’s death. This is not an estimate you can guess at later — it needs to be documented.
For real estate, a formal appraisal conducted at or near the time of death is the standard approach. For publicly traded securities, the FMV is typically the average of the high and low prices on the date of death. If you cannot prove the basis to the IRS, they have the authority to treat it as zero — which would mean full capital gains tax on the entire sale price.
Acting promptly matters. Getting an appraisal done in the weeks immediately following a death is far easier than trying to reconstruct value years later when you decide to sell.
Estate Tax vs. Capital Gains Tax
These are two separate taxes, and it’s important not to confuse them.
Estate tax is levied on the total value of a decedent’s estate before assets are transferred to heirs. For 2025, the federal estate tax exemption is $13.61 million per individual (or $27.22 million for married couples). Most estates don’t owe federal estate tax — but California has no separate state estate tax, so only the federal threshold applies here.
Capital gains tax is what an heir owes if and when they sell an inherited asset at a profit above the stepped-up basis. The step-up in basis is specifically a capital gains tax benefit — it does not reduce estate tax. Both taxes can potentially apply to the same estate, depending on its size.
Key distinction: The step-up in basis does not reduce estate tax. It reduces or eliminates capital gains tax that heirs would otherwise owe when they sell inherited assets. Large estates may still owe estate tax — consult an estate planning attorney if this is a concern.
Assets That Qualify for Step-Up in Basis
The step-up applies broadly to assets included in a decedent’s taxable estate. Common qualifying assets include:
Real Estate
Residential homes, rental properties, commercial buildings, and raw land all qualify — including properties acquired through 1031 exchanges.
Stocks & Bonds
Individually held shares, mutual funds, ETFs, and bonds receive a stepped-up basis to their fair market value on the date of death.
Business Interests
Ownership stakes in partnerships, LLCs, S corporations, and other pass-through entities generally qualify if included in the estate.
Collectibles
Art, antiques, jewelry, wine, classic cars, and similar tangible assets held at death qualify for the step-up in basis.
Assets That Do Not Qualify
Not every asset benefits from a step-up. The following are notable exceptions:
- IRAs and tax-deferred retirement accounts: Distributions from inherited traditional IRAs are taxed as ordinary income. There is no step-up in basis for these accounts.
- Annuities: Earnings inside inherited annuities are generally subject to income tax when withdrawn.
- Property gifted during the owner’s lifetime: If someone gives you an appreciated asset while they’re still alive, you inherit their original cost basis — not the current fair market value. This is a critical distinction: waiting to inherit is often far more tax-efficient than receiving an asset as a gift.
Date of Death Valuation
Establishing the stepped-up basis requires careful documentation of fair market value at the time of death. Here’s what that typically looks like for real estate:
- Hire a licensed appraiser to conduct a retrospective appraisal as close to the date of death as practical
- Retain a copy of the appraisal report in a secure place you can access years later if needed
- If the estate goes through probate, the probate court may also establish values for major assets
- For properties in trust, the trustee typically handles this documentation Don’t wait years to sell and then scramble to prove what the property was worth at the time of the original owner’s death. Establishing value promptly protects you and simplifies the eventual sale.
Planning Strategies That Use Step-Up in Basis
Understanding the step-up in basis opens the door to several estate planning strategies. Here are five worth knowing about — and worth discussing with a qualified advisor:
- 1
Hold appreciated assets until death If you own real estate or other assets with very low cost basis and significant unrealized gains, holding them rather than selling during your lifetime allows your heirs to inherit at fair market value. The lifetime gain is never taxed as capital gains. 2. 2
Use 1031 exchanges to defer, then step-up to erase A savvy investor can use a series of 1031 exchanges to continuously defer capital gains throughout their lifetime, then pass the properties to heirs who receive a stepped-up basis — permanently eliminating all deferred taxes. More on this below. 3. 3
Community property advantages California is a community property state. When one spouse dies, the surviving spouse receives a step-up in basis on both halves of community property — not just the decedent’s half. This full step-up can significantly reduce future capital gains taxes compared to common law property states. 4. 4
Give cash, inherit assets Because gifted assets carry the donor’s original cost basis rather than receiving a step-up, it is often better to gift cash or other low-appreciation assets during your lifetime and hold highly appreciated property until death. The recipient inherits the appreciated property with a stepped-up basis. 5. 5
Coordinate with your estate plan Trusts, beneficiary designations, and titling decisions all affect whether a step-up in basis is available. Assets held in certain irrevocable trusts may not qualify. Work with your estate planning attorney to ensure the assets you want stepped up are structured appropriately.
What About 1031 Exchange Properties?
This is where things get particularly interesting for real estate investors.
A 1031 exchange (under IRS Code §1031) lets you defer paying capital gains taxes when you sell investment real estate and reinvest the proceeds into a “like-kind” property. You carry over your original cost basis into the new property — the tax is deferred, not eliminated.
But here’s the powerful part: if you hold that 1031 exchange property until death, your heirs inherit it at fair market value on the date of your death. According to First American Exchange Company, all of the capital gains deferred across every prior exchange are permanently erased — never taxed.
Example: You bought a rental property in 1995 for $150,000. Over two decades you completed three 1031 exchanges, growing the portfolio to a property now worth $2.2 million. Your carried-over basis is still close to $150,000. If you sell, you owe capital gains tax on roughly $2.05 million. But if you hold the property until death, your heirs inherit at $2.2 million FMV — and that $2.05 million in deferred gains is gone permanently.
This strategy — sometimes called “defer, defer, die” among tax planners — is entirely legal and codified in U.S. tax law. It’s one reason why long-term real estate investment, combined with thoughtful estate planning, can be so powerful as a wealth-building and wealth-transfer tool.
It’s worth noting that heirs who inherit 1031 exchange property with a stepped-up basis can, in some circumstances, also use a future 1031 exchange on that property if they put it to investment use — though the rules are nuanced. Consult a qualified exchange facilitator and tax advisor before assuming that’s an option.
The Bottom Line
The step-up in basis is not a loophole — it’s a deliberate feature of U.S. tax law, codified in Internal Revenue Code §1014, designed in part to prevent the double taxation of assets that were already subject to estate tax. But understanding how to use it strategically is where the real planning value lies.
For heirs who stand to inherit appreciated California real estate, the step-up can represent hundreds of thousands of dollars in tax savings. For investors building a portfolio through 1031 exchanges, it can be the final chapter of a decades-long strategy to transfer wealth without triggering the capital gains taxes that accumulated along the way.
As a real estate agent, I don’t give tax advice — that’s your CPA’s and estate attorney’s domain. But I can help you think through how a potential sale, inheritance, or exchange fits into the bigger picture, and connect you with the right specialists. If you’re working through any of this in the context of Santa Cruz County real estate, I’m happy to be a resource. For a sense of current market values, the market stats page has recent data.
Questions About Inherited Property or 1031 Exchanges?
Whether you’re navigating an inheritance, planning a 1031 exchange, or thinking through an estate strategy, I’m happy to talk through the real estate side with you — and connect you with the right specialists for the legal and tax pieces.
Frequently Asked Questions
What is step-up in basis? When you inherit property, U.S. tax law resets the cost basis of that asset to its fair market value on the date of the original owner’s death. Any appreciation that occurred during the decedent’s lifetime is effectively wiped clean — you are not taxed on gains you never personally realized. Learn more at First American Exchange Company.
Does step-up in basis apply to 1031 exchange properties? Yes. When a taxpayer who used 1031 exchanges to defer capital gains passes away, their heirs inherit the property at its fair market value on the date of death. According to First American Exchange Company, the deferred gains from all prior exchanges are permanently erased — never taxed. It’s one of the most compelling reasons to hold exchange properties long-term.
What assets qualify for step-up in basis? Real estate, stocks and bonds, business interests, and collectibles generally qualify. Assets that do not qualify include IRAs and tax-deferred retirement accounts, annuities, and property gifted during the owner’s lifetime. See firstexchange.com for additional resources on how this interacts with investment real estate.
What is the difference between estate tax and capital gains tax? Estate tax is levied on the total value of a decedent’s estate before assets are transferred to heirs. Capital gains tax is owed when an heir later sells an inherited asset at a profit above the stepped-up basis. The step-up in basis addresses capital gains tax — not estate tax. Both can apply to the same estate depending on its size. Consult a qualified estate planning attorney for guidance on your specific situation.
How is fair market value established at the date of death? For real property, a formal appraisal conducted at or near the time of death is the standard method. The IRS requires documentation; if no basis can be proven, the IRS may treat it as zero. Acting promptly to establish value protects heirs. First American Exchange Company and other exchange facilitators can also provide guidance on how basis documentation works in the context of 1031 exchange properties.
Can you use a 1031 exchange on inherited property? In most cases an heir can use a 1031 exchange if they convert the inherited property to investment use. However, the rules around inherited property and exchanges are nuanced — consult a qualified exchange facilitator such as First American Exchange Company and a tax advisor before proceeding. As your real estate agent, I can handle the property search and transaction side while the exchange facilitator manages the legal structure.