Step-Up Basis + Community Property Double Step-Up

Step-up in basis under IRC §1014 is one of the largest tax breaks in the federal code — arguably the largest by aggregate dollar value. It resets the basis of inherited property to its fair market value at the decedent's date of death, wiping out all unrealized appreciation accumulated during the decedent's ownership. A $5M brokerage account with $4M of embedded gain transfers to heirs with $0 of unrealized gain. The lifetime tax on that $4M of appreciation — potentially $952,000 at the top combined federal LTCG + NIIT rate — is permanently eliminated.

But the magnitude of the step-up depends critically on a single jurisdictional fact: was the property held in a community property state or a common-law state at the time of the first spouse's death? The 9 community property states get the famous "double-step-up" under IRC §1014(b)(6). The 41 common-law states get only a "half-step-up." On the same $4M home with $400K basis, the difference is roughly $850K-$952K in eventual capital gains tax. This is the single largest geographic tax variation in the IRC.

How step-up basis under IRC 1014 works

Under IRC §1014(a)(1), the basis of property acquired from a decedent is its fair market value at the date of the decedent's death (or, if the executor elects alternate valuation under IRC §2032, the FMV 6 months after death). The original cost basis paid by the decedent during life is irrelevant. The basis is replaced.

This applies to virtually all inherited property:

• Brokerage accounts and investment securities: mutual funds, ETFs, stocks, bonds — all step up to date-of-death FMV under §1014.
• Real property: primary residences, vacation homes, rental properties, land — all step up.
• Closely-held business interests: stock in private companies, partnership interests, LLC membership interests — step up subject to valuation discounts.
• Personal property: art, collectibles, vehicles, jewelry — step up to FMV at death.

Notable exclusions:

• Income in respect of a decedent (IRD) under IRC §691: traditional IRAs, 401(k)s, 403(b)s, deferred compensation, unpaid wages. These retain the decedent's basis and produce ordinary income to the heir when distributed.
• Inherited Roth IRAs: not stepped up (because they have no embedded ordinary income to recognize), but already tax-free at distribution.
• Property the decedent gifted within 1 year of death where the donor reacquires by bequest: §1014(e) anti-abuse rule prevents the step-up.

The community property double-step-up under IRC 1014(b)(6)

IRC §1014(b)(6) is the special provision that creates the community property double-step-up. The statutory language: "property acquired from the decedent" for §1014 purposes includes "the surviving spouse's one-half share of community property held by the decedent and the surviving spouse under the community property laws of any State."

What this means in practice: when one spouse dies holding community property, the entire community property — both the decedent's half and the surviving spouse's half — receives a step-up to date-of-death FMV. The surviving spouse's half gets the step-up benefit even though that spouse is still alive and the property never "passed" to anyone.

By contrast, in a common-law state (non-community-property state), jointly-held property is governed by state ownership rules. At the first spouse's death:

• The decedent's half (typically 50% under joint tenancy) gets a step-up under §1014(a).
• The surviving spouse's half retains the original carryover basis.
• The resulting new basis is the weighted average: 50% × FMV at death + 50% × original basis. This is the "half-step-up."

Worked comparison: $4M home with $400K original basis

Husband and wife purchased a primary residence for $400K several decades ago. The home is now worth $4M. Husband dies. Wife inherits everything.

If they lived in California (community property state):

• Date-of-death FMV: $4,000,000
• Step-up under IRC §1014(b)(6): full FMV applies to entire community property
• Wife's new basis: $4,000,000
• If she sells the home for $4.05M one year later: capital gain = $50K (after the §121 $250K primary-residence exclusion for single filers post-death, gain = $0).
• Federal capital gains tax: $0

If they lived in Massachusetts (common-law state):

• Date-of-death FMV: $4,000,000
• Husband's 50% share steps up: 50% × $4,000,000 = $2,000,000 new basis component
• Wife's 50% share retains carryover basis: 50% × $400,000 = $200,000 carryover
• Wife's combined new basis: $2,200,000
• If she sells the home for $4.05M one year later: capital gain = $4,050,000 - $2,200,000 = $1,850,000
• After §121 $250K primary-residence exclusion (single filer post-death): taxable gain = $1,600,000
• Federal capital gains tax at 20% + 3.8% NIIT = 23.8%: $380,800

The community property double-step-up saves this Massachusetts couple $380,800 compared to the half-step-up — entirely from a geographic / property-law difference that has nothing to do with the federal tax code per se but everything to do with how §1014(b)(6) interacts with state community-property law.

The 9 community property states

The 9 community property states under IRC §1014(b)(6):

1. California — spousal community property under Cal. Fam. Code §760. Community property since 1850.
2. Arizona — ARS §25-211. Community property since territorial statehood.
3. Idaho — Idaho Code §32-906. Community property since territorial statehood.
4. Louisiana — LA CC Art. 2334. Community property since French/Spanish colonial era (the only state with French civil law roots).
5. Nevada — NRS Ch. 123. Community property since 1873.
6. New Mexico — NMSA §40-3-8. Community property since territorial statehood.
7. Texas — Tex. Fam. Code §3.002. Community property since Spanish colonial era.
8. Washington — RCW §26.16.030. Community property since 1879.
9. Wisconsin — Wis. Stat. §766.31. Marital property (functionally equivalent to community property for §1014(b)(6) purposes) since 1986 under the Wisconsin Marital Property Act.

The list is geographically clustered in the Southwest and West, reflecting historical Spanish, Mexican, and French civil law influence (Texas, California, New Mexico, Arizona, Nevada, Louisiana) plus territorial-era adoption (Idaho, Washington) and a modern statutory adoption (Wisconsin).

What is NOT a community property state: Florida (despite the retirement population), New York (despite the wealth concentration), Illinois, Massachusetts, Pennsylvania, Ohio, Michigan, North Carolina, Georgia — and 41 others. All of these are common-law states where only the half-step-up applies.

Opt-in community property trusts: the workaround for common-law states

Three states — Alaska, Tennessee, and South Dakota — offer optional community property trust statutes that allow couples residing in common-law states to convert separately-owned property into community property for federal tax purposes. The mechanism: the couple creates an irrevocable trust under the chosen state's community property trust statute, transfers selected assets into the trust, and the trust treats those assets as community property for IRC §1014(b)(6) purposes.

The leading vehicles:

• Alaska Community Property Trust (ACPT): under Alaska Stat. §34.77.090 et seq. Available to non-Alaska-resident couples. Requires an Alaska resident trustee (typically a corporate trust company in Anchorage or Juneau).
• Tennessee Community Property Trust (TCPT): under Tenn. Code Ann. §35-17-101 et seq. Available to non-Tennessee-resident couples. Requires a Tennessee resident trustee.
• South Dakota Special Spousal Trust: under SDCL §55-17-1 et seq. Available to non-SD-resident couples.

The IRS has not formally blessed every aspect of these trusts (no specific ruling extends §1014(b)(6) to opt-in trusts), but the prevailing practitioner view — supported by the structure of §1014(b)(6) and the language of the state statutes — is that properly-drafted opt-in community property trusts qualify for the double-step-up. The conservatism of this position varies by tax counsel. For high-stakes families, the additional certainty of physically relocating to a community property state may be worth more than the tax savings, but for many families the opt-in trust is a viable alternative.

When the opt-in trust is worth it

The opt-in community property trust is generally worth considering when:

• The couple has at least $2M of appreciated assets with low basis that they intend to hold to the first spouse's death.
• Both spouses are willing to permanently convert the assets to community property (which means the assets are equally owned even in the event of divorce — a material consideration for second marriages or where one spouse contributed the assets pre-marriage).
• The trust setup cost (typically $5K-$15K) and ongoing trust administration (annual fees of $2K-$8K) are small relative to the projected tax savings.
• The couple does not anticipate relocating to a community property state in any case.

The opt-in trust is generally NOT worth it when:

• The appreciated assets are likely to be sold during the couple's lifetime anyway (no step-up benefit to capture).
• The couple is in a second marriage and wants to maintain separate property characterization for divorce-protection purposes.
• The total appreciation is modest enough that the tax savings don't justify the trust costs.
• The couple has flexible domicile and could relocate to California, Texas, or another community property state for retirement.

Step-up basis erosion: the legislative history of risk

Step-up basis is one of the largest single-item tax expenditures in the federal code, costing roughly $40-50 billion per year in foregone revenue per Joint Committee on Taxation estimates. This makes it a perennial target for repeal or limitation in tax-reform proposals.

The most notable historical example: the 1976 Tax Reform Act replaced step-up basis with "carryover basis" for inherited assets (heirs inherit at the decedent's original cost basis, not date-of-death FMV). The carryover basis rule was enacted but never took effect — it was retroactively repealed in 1980 before it could be applied to any actual estate, due to massive implementation difficulties (executors couldn't reconstruct the original basis of decades-old assets).

More recent proposals:

• 2021 American Families Plan: proposed treating death as a realization event for capital gains above $1M per individual ($2.5M for joint), with gains taxed immediately at the decedent's rates. Did not become law.
• STEP Act (Sensible Taxation and Equity Promotion Act): proposed eliminating step-up basis entirely for gains above $1M ($2M MFJ). Did not become law.
• OBBBA (2025): did not modify step-up basis. The $13.99M federal estate exemption was extended permanently, but §1014 was not addressed.

Planning implications: families with concentrated low-basis assets ($1M+ embedded gains) should monitor proposed legislation closely. If step-up basis appears likely to be eliminated, the planning move is generally to not sell appreciated assets in advance (paying capital gains tax at known rates is rarely better than holding for an uncertain step-up that may still apply). The more relevant moves are: (a) using lifetime gift exemption to remove assets from the estate before basis erosion takes effect, (b) consider strategic Roth conversions for retirement-account-heavy estates, and (c) prepare for the administrative burden of tracking carryover basis on inherited assets if §1014 is amended.

The interaction with federal estate planning: the gift-vs-hold trade-off

Step-up basis creates a critical trade-off in federal estate planning. For families above the federal exemption ($13.99M single / $27.98M couple in 2026), the choice between (a) leaving assets in the federal taxable estate (40% estate tax, but step-up applies) versus (b) gifting assets out of the estate during life (no estate tax on gifted assets, but no step-up — carryover basis to the donee) depends on the math of each path.

The math: holding in the estate saves 23.8% capital gains tax on the unrealized gain (step-up benefit) but pays 40% estate tax on the entire asset value. Gifting saves 40% estate tax but pays 23.8% capital gains tax on the appreciation when the heir sells.

For assets with high embedded gain percentage (e.g., $1M home with $100K basis — 90% appreciation), the gift-with-carryover-basis path costs the heir 23.8% × 90% = 21.4% effective tax at sale. The estate-with-step-up path costs 40% federal estate tax on the full asset. Gifting wins by ~18.6 percentage points.

For assets with low embedded gain percentage (e.g., $1M brokerage with $900K basis — 10% appreciation), gift carryover costs 23.8% × 10% = 2.38% at sale. Estate step-up costs 40% federal estate tax. Gifting wins by ~37.6 percentage points.

For assets in the federal estate (below $13.99M exemption, so no estate tax): step-up always wins because there is no offsetting estate tax cost. The gift path makes sense only for assets that would otherwise be subject to the 40% federal estate tax above the exemption.

State-level interactions: no separate state step-up

Step-up basis is a federal income tax rule under IRC §1014. There is no separate state-level step-up provision — states that have an income tax simply follow the federal basis convention. This means:

• States with a state income tax (43 states + DC) apply federal step-up basis to state income tax calculations as well. The wife in the California example pays $0 in California state capital gains tax because her California basis is also $4M (community property double-step-up applies for federal purposes, and California conforms).
• States with no income tax (FL, TX, NV, WY, SD, TN, WA, AK, NH) have no state capital gains tax to worry about — step-up is irrelevant at the state level.
• Washington has a 7% capital gains tax on LT gains over $250K (since 2022), so step-up affects the Washington state tax calculation. Washington is also a community property state, so the double-step-up applies for both federal and state purposes.

The state-level interaction matters most for high-tax states like California (13.3% top rate) where eliminating embedded gain through step-up saves both federal and state capital gains tax.

Common step-up basis mistakes

• Failing to document basis at date of death: heirs and executors must obtain qualified appraisals (or sufficient market evidence) of date-of-death FMV. Without documentation, the IRS can challenge the step-up at audit. For real property, an estate appraisal by a licensed appraiser is standard. For closely-held businesses, a qualified business valuation is required.
• Selling within a year of death without filing Form 8971: heirs must file Form 8949 reporting the inherited basis, and large estates must file Form 8971 reporting basis information to the IRS and heirs under IRC §6035. Failure to file Form 8971 timely can result in penalties and basis challenges.
• Not claiming the community property double-step-up: couples in community property states often fail to assert §1014(b)(6) on the surviving spouse's subsequent sale, missing the full basis adjustment. The estate's Form 706 should clearly identify community property; the surviving spouse's subsequent basis records should reflect the full step-up.
• Forgetting that retirement accounts don't step up: heirs inheriting traditional IRAs and 401(k)s sometimes assume the step-up applies. It does not — these are IRD and produce ordinary income to the heir.
• Triggering §1014(e) by gifting and inheriting back: if the decedent received a gifted appreciated asset within 1 year of death and the donor (the original gifter) is the inheriting party, the §1014(e) anti-abuse rule denies the step-up. This blocks the "gift to dying spouse for step-up" arbitrage but only between specific donor-donee combinations.
• Holding the wrong assets in the wrong account: if appreciated assets are held in retirement accounts (which don't step up), the family loses the §1014 benefit on those assets. High-asset estate planning generally aims to hold appreciated assets in taxable brokerage (step-up applies) and use retirement accounts for fixed-income and other lower-appreciation holdings.

Decision framework: who needs active step-up planning?

1. Couples in the 9 community property states with $1M+ of appreciated assets: the double-step-up is automatic. Just document the community property characterization carefully so it can be claimed at the first spouse's death.
2. Couples in common-law states with $2M+ of appreciated assets they intend to hold to first death: seriously consider an Alaska, Tennessee, or South Dakota community property trust to capture the double-step-up. Setup cost $5K-$15K vs. tax savings of $100K-$500K+.
3. High-asset families (federal estate exemption-relevant): model the gift-vs-hold trade-off carefully. For assets with high embedded gain, gift-and-carryover often wins; for low-embedded-gain assets, hold-and-step-up often wins.
4. Families with concentrated low-basis assets: monitor step-up basis erosion legislation. Be prepared to accelerate gifting if elimination becomes likely.
5. Families with retirement account heavy estates: consider lifetime Roth conversions to convert IRD (no step-up, ordinary income to heirs) into Roth (tax-free distributions to heirs). The conversion tax paid during life is the cost of converting the heirs' tax burden from ordinary income to zero.

Key takeaways

• Step-up basis under IRC 1014 resets inherited assets to date-of-death FMV, eliminating all unrealized appreciation during the decedent's lifetime. This is one of the largest single tax breaks in the federal code.
• The community property double-step-up under IRC 1014(b)(6) applies in 9 states: California, Arizona, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. The entire community property — not just the decedent's half — steps up at the first spouse's death.
• On a $4M community property home with $400K original basis, the double-step-up saves the family approximately $380K in capital gains tax compared to the half-step-up available in the 41 common-law states.
• Common-law-state couples can use opt-in community property trusts in Alaska, Tennessee, or South Dakota to convert separately-owned property to community property for §1014(b)(6) purposes. Setup cost $5K-$15K; tax savings often $100K-$500K+ on $2M+ of appreciated assets.
• Step-up basis does NOT apply to retirement accounts (IRD under IRC §691). Inherited traditional IRAs, 401(k)s, and deferred compensation retain the decedent's basis and produce ordinary income to heirs.
• Step-up basis erosion is a non-trivial legislative risk. The 1976 carryover-basis experiment, the 2021 American Families Plan proposal, and ongoing STEP Act introductions all signal continuing scrutiny of §1014. Families with concentrated low-basis estates should monitor proposed legislation.
• For estates above the federal exemption, the gift-vs-hold trade-off depends on the embedded-gain percentage. High-appreciation assets generally favor gifting (40% estate tax avoided exceeds 23.8% capital gains cost). Low-appreciation assets generally favor holding (step-up benefit exceeds the 40% estate tax cost).