When a loved one passes away, the tax implications of inherited property are often the last thing on a grieving family’s mind. Yet, understanding the concept of a step-up in basis is critical for preserving wealth and avoiding unexpected tax bills. While the general rule under Internal Revenue Code Section 1014 allows the cost basis of most inherited assets to be adjusted to their fair market value (FMV) on the date of the decedent’s death, this generous tax benefit does not apply universally. Knowing exactly what assets do not get a step-up in basis is essential for effective estate planning and accurate tax filing Simple as that..
The General Rule: How Step-Up in Basis Usually Works
Before diving into the exceptions, it helps to understand the standard mechanism. If they sell it immediately for $100,000, they owe zero capital gains tax on the $90,000 appreciation that occurred during your lifetime. Typically, if you buy a stock for $10,000 and it is worth $100,000 when you die, your heir’s new "cost basis" becomes $100,000. This "step-up" (or occasionally "step-down" if values dropped) wipes out the latent capital gain.
That said, the tax code carves out specific categories of property defined as Income in Respect of a Decedent (IRD) and other specific exclusions where the basis does not reset. For these assets, the heir inherits the decedent’s original carryover basis, meaning the built-in gain remains taxable upon eventual sale Worth keeping that in mind. Surprisingly effective..
Assets Classified as Income in Respect of a Decedent (IRD)
The most significant category of assets denied a step-up in basis falls under the umbrella of Income in Respect of a Decedent (IRD). In practice, iRD represents income the decedent had a right to receive but had not yet recognized for tax purposes before death. Because the decedent never paid income tax on this money, the IRS requires the beneficiary to pay it—and crucially, the basis remains zero or the decedent’s adjusted basis, not the FMV at death It's one of those things that adds up..
1. Traditional Retirement Accounts (IRAs, 401(k)s, 403(b)s)
This is the most common "gotcha" for heirs. Contributions to traditional pre-tax retirement accounts were made with pre-tax dollars, and earnings grew tax-deferred. The decedent never paid income tax on these funds.
- No Step-Up: The beneficiary inherits the account with a carryover basis of zero (for pre-tax contributions/earnings).
- Tax Consequence: Every dollar distributed to the beneficiary is taxed as ordinary income at the beneficiary’s marginal tax rate.
- Note on Roth Accounts: Roth IRAs and Roth 401(k)s are fundamentally different. Because contributions were made post-tax and qualified distributions are tax-free, they generally do receive a step-up in basis for the earnings portion if the five-year rule is met, though the distribution rules (10-year rule under SECURE Act) still apply.
2. Non-Qualified Annuities
Similar to traditional retirement accounts, non-qualified annuities grow tax-deferred. The gain portion of the contract (value minus principal investment) is IRD Easy to understand, harder to ignore..
- No Step-Up on Gains: The beneficiary inherits the decedent’s original cost basis (the principal paid in). The deferred gain is taxed as ordinary income to the beneficiary as withdrawals are made.
- Exception: If the annuity was annuitized (turned into a payment stream) before death, the exclusion ratio calculation carries over, but the underlying deferred gain still lacks a step-up.
3. U.S. Savings Bonds (Series EE and I)
Many taxpayers defer reporting interest on savings bonds until redemption or maturity. If the bondholder dies while deferring that interest, the accrued interest up to the date of death is IRD Nothing fancy..
- No Step-Up: The beneficiary must report the accrued interest as income on their return (or the estate’s return) when the bonds are redeemed. The basis does not step up to the FMV including that interest.
4. Unpaid Salary, Wages, Bonuses, and Vacation Pay
If an employer owes the decedent compensation for services rendered before death—such as a final paycheck, accrued vacation pay, or a declared but unpaid bonus—this is IRD Still holds up..
- No Step-Up: The estate or beneficiary reports this as ordinary income. There is no capital asset here to receive a basis adjustment; it is pure income recognition.
5. Installment Sale Receivables (Notes Receivable)
If the decedent sold property on an installment plan and was reporting the gain over time using the installment method (IRC Section 453), the remaining unreported gain on the note is IRD.
- No Step-Up on the Note: The beneficiary inherits the note with the decedent’s basis in the obligation. As payments are collected, the beneficiary must report the same proportion of gain the decedent would have reported. The underlying property sold might have received a step-up if it was still owned, but the receivable note itself does not.
6. Accounts Receivable for Cash-Basis Taxpayers
For a business owner using the cash method of accounting, income is recognized when received. Outstanding invoices at death represent income earned but not yet received Simple, but easy to overlook..
- No Step-Up: These receivables are IRD. The estate or beneficiary recognizes ordinary income upon collection. The basis in the receivable is zero.
Other Specific Assets Denied a Step-Up
Beyond the IRD category, several other asset types are explicitly excluded from the basis adjustment rules under IRC Section 1014.
7. Property Gifted Within One Year of Death (The "Boomerang" Rule)
Under IRC Section 1014(e), if a decedent received property by gift within one year of their death, and that property is returned to the original donor (or the donor’s spouse), no step-up is allowed No workaround needed..
- Purpose: This prevents "basis shifting" schemes where an appreciated asset is gifted to a dying relative solely to get a step-up and then gifted back.
- Result: The basis remains the donor’s original carryover basis (the basis the donor had when they gifted it).
8. Certain Trust Assets (Grantor Trusts & Bypass Trusts)
The trust structure dictates basis treatment.
- Irrevocable Trusts (Completed Gifts): Assets placed in an irrevocable trust (like an Irrevocable Life Insurance Trust or a completed gift trust) during the grantor's lifetime are generally not included in the grantor's gross estate. This means they do not receive a step-up at the grantor's death. The beneficiaries retain the carryover basis.
- Bypass / Credit Shelter Trusts (B Trusts): When the first spouse dies, assets funding the "B Trust" (up to the estate tax exemption) receive a step-up at the first death. On the flip side, when the surviving spouse dies, the assets remaining in that B Trust do not receive a second step-up. They retain the basis established at the first spouse's death.
- Grantor Trusts (Intentionally Defective Grantor Trusts - IDGTs): Because the grantor is treated as the owner for income tax purposes but the trust is irrevocable for estate tax purposes, assets in an IDGT typically do not get a step-up at the grantor's death since they are outside the estate.
9. Property Held in a Qualified Terminable Interest Property (QTIP) Trust — Nuance
Assets in a QTIP trust do get a step-up at the first spouse's death (because they are included in
9. Property Held in a Qualified Terminable Interest Property (QTIP) Trust — Nuance
Assets in a QTIP trust do get a step-up at the first spouse's death (because they are included in the decedent's gross estate for income tax purposes). If the QTIP trust contains both a general and preferential share, the preferential share receives a full step-up, while the general share remains subject to the original basis of the assets. Even so, the step-up is limited to the amount of the interest the surviving spouse has a right to receive. This nuanced treatment ensures that the estate does not gain an additional value beyond what was taxed at the first death, while still providing the surviving spouse with a fair share of the appreciation Small thing, real impact. Surprisingly effective..
10. Assets Held by Minors or Certain Trusts for Minors
The Internal Revenue Code provides specific guidance on how basis is treated for property held by minors or by trusts established for minors. Under IRC Section 1014(b), basis is not stepped up for property held by a minor or the minor’s estate. Practically speaking, this rule is designed to prevent premature recognition of income that would otherwise be deferred by the minor’s temporary lack of legal capacity to enter into contracts. Now, consequently, the basis of such property remains unchanged upon the minor’s death and is carried forward to the beneficiary. Similar treatment applies to property held by a trust for a minor, where the trust’s income is taxed at the trust level, and basis adjustments are generally omitted for the benefit of the minor beneficiary Which is the point..
11. Certain Agricultural Property
Agricultural property is another asset class that may not receive a step-up under certain circumstances. When property is transferred to a successor in interest during the decedent’s life, a step-up may be denied if the property is used for farming or grazing and the transfer is made in connection with a business or investment purpose. The tax code aims to preserve the economic reality that agricultural assets often require sustained management to generate meaningful returns, and a full step-up would artificially inflate the value of the estate without providing additional tax benefits to the estate. In such cases, the basis of the property remains the original cost minus any adjustments made under prior rules, and the surviving farmer or business partner recognizes income upon the sale of the property.
12. Real Property Held by the Government
Real property owned by the federal government, state government, or a local municipality may also be excluded from step-up rules. This exclusion is rooted in the public interest in maintaining the tax base for future development and infrastructure. Day to day, if real property is transferred to the government, the basis is generally not stepped up at the decedent’s death. Here's the thing — instead, the government assumes the liability and risk associated with the asset. Upon the government’s eventual disposition of the property, the sale proceeds are taxed as ordinary income to the government, and no basis adjustment is made to the estate. This treatment aligns with the principle that public assets should not be subject to the same step-up benefits as private property, as their purpose is not to generate private wealth but to serve community needs.
13. Retirement Accounts and Certain Investment Vehicles
Assets held in traditional or Roth IRAs, 401(k) plans, and similar retirement accounts are not subject to step-up rules in the same manner as other assets. Plus, these accounts are designed to defer or eliminate income taxation, and the IRS has determined that a basis step-up would undermine the purpose of these vehicles. When a retirement account is transferred to a beneficiary (such as a surviving spouse or a child), the basis is generally carried over from the original owner without adjustment. The tax benefit of these accounts is preserved through the account itself, and any growth inside the account accrues to the beneficiary at a preferential rate of 0% for Roth contributions or traditional contributions subject to income tax. This structure ensures that retirement savings remain tax-advantaged rather than being subject to the same income recognition rules that apply to other forms of property But it adds up..
14. Conclusion
The rules governing step-up of basis for decedents are nuanced and context-dependent, reflecting the tax code’s balancing act between encouraging economic growth and ensuring equitable taxation of wealth transfers. While many assets—such as cash-based business receivables, property gifted within one year of death, and certain trust assets—are explicitly excluded from basis adjustments, others, including agricultural property and government-owned real estate, also fall outside these provisions. Additionally, specific trust structures and property held
14. Conclusion (continued)
Additionally, specific trust structures and property held in grantor‑trust arrangements are treated as separate taxable entities for basis purposes. Day to day, when a decedent transfers assets into a trust that is not a qualified terminable interest property (QTIP) trust, the basis generally carries over to the trust rather than receiving a step‑up at the decedent’s death. This approach preserves the original owner’s tax attributes and prevents the erosion of the tax base through successive basis adjustments. Similarly, property held in certain charitable remainder trusts or revocable living trusts may be excluded from step‑up treatment, as the tax code seeks to maintain the intended charitable or estate‑planning benefits of these vehicles.
The cumulative effect of these exclusions is to check that the step‑up in basis—while a powerful tool for reducing capital gains tax on inherited assets—does not indiscriminately apply to every form of property. By carving out categories such as cash‑based business receivables, recently gifted property, government‑owned real estate, retirement accounts, and specialized trust assets, the tax system upholds broader policy goals: encouraging investment, protecting the tax base, and preserving the integrity of retirement and charitable savings vehicles. Taxpayers and practitioners must therefore carefully evaluate each asset’s characteristics to determine whether a step‑up is permissible, as misclassification can lead to unexpected tax liabilities or missed opportunities for tax efficiency.
In sum, the step‑up in basis remains a cornerstone of estate taxation, yet its application is deliberately limited to align with economic, social, and fiscal objectives. Understanding these nuanced exclusions not only aids in accurate tax reporting but also supports informed estate planning that respects both individual wealth transfer goals and the public interest.
