Step-Up Basis Erosion: When the Carryover-Basis Risk Returns

The step-up in basis is deceptively simple: when you inherit property, your cost basis for capital gains purposes is the fair market value at the date of the decedent's death under IRC section 1014. If your mother bought shares of a company for $30,000 in 1990 and they were worth $600,000 when she died, your basis is $600,000. You can sell the next day and owe zero capital gains tax on the $570,000 of appreciation that accrued during her lifetime. That gain is never taxed — not at her death, not at your sale, not ever.

This provision transfers an estimated $40-50 billion per year in unrealized capital gains without income taxation, according to Joint Committee on Taxation and Treasury Department analyses. It is, by revenue impact, one of the largest tax expenditures in the federal code. It is also one of the most politically durable — Congress has tried to eliminate it twice and failed both times. But the conditions that make repeal attractive to budget writers have not changed, and the 2025 TCJA sunset creates a legislative window where the step-up could again become a bargaining chip.

How IRC section 1014 works: the mechanics

IRC section 1014(a)(1) provides that the basis of property "acquired from a decedent" is the fair market value of the property at the date of the decedent's death. The alternate valuation date under IRC section 2032 allows the executor to elect a valuation date six months after death if it reduces the gross estate — this alternate date then becomes the heir's basis as well.

"Acquired from a decedent" includes property passing by will, intestacy, trust (including revocable trusts whose assets are included in the gross estate under IRC section 2038), joint tenancy (to the extent included in the gross estate under IRC section 2040), and certain other transfers. The step-up applies to the property's entire fair market value — not just the portion of appreciation that occurred after some arbitrary date.

The step-up is actually a basis adjustment, not always an increase. If the decedent bought property at $500,000 and it was worth $300,000 at death, the heir's basis is $300,000 — a step-down. The heir cannot claim a capital loss on the $200,000 decline that occurred during the decedent's lifetime. This is occasionally relevant for depreciated real estate or concentrated stock positions that declined before death.

The 1976 carryover-basis experiment: what went wrong

The Tax Reform Act of 1976 replaced the step-up with a carryover basis for property inherited after December 31, 1976. Under the new rules, heirs would take the decedent's original cost basis, adjusted for certain items, and owe capital gains tax on all pre-death appreciation when they eventually sold.

The provision was a disaster before it ever took effect. The fundamental problem was records: executors and heirs had no way to determine what the decedent originally paid for assets acquired decades earlier. A family farm purchased in 1945 — what was the basis? A stock portfolio assembled through dividend reinvestment plans over 30 years — what were the individual lot costs? A personal residence improved, expanded, and partially converted to rental use over 40 years of ownership — what was the adjusted basis?

Congress delayed the effective date three times. The IRS issued proposed regulations that ran over 100 pages attempting to address the record-keeping requirements. Practitioners and taxpayer advocacy groups argued the provision was unconstitutional, unworkable, and unfair. In 1980, Congress retroactively repealed the carryover basis — it never applied to a single estate.

The 2010 optional carryover basis: a limited test

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) phased out the federal estate tax over a decade, eliminating it entirely for 2010. With no estate tax, there was no policy justification for the step-up in basis (which existed partly to offset the estate tax burden). Congress replaced the step-up with a modified carryover basis under IRC section 1022 for 2010 decedents.

The 2010 rules were more generous than the 1976 version. Executors could allocate a $1.3 million general basis increase across estate assets, plus a $3 million additional increase for property passing to a surviving spouse. Assets receiving the allocated increase got a stepped-up basis (up to fair market value); the remainder carried over the decedent's original basis.

In December 2010, Congress retroactively reinstated the estate tax for 2010 with a $5 million exemption and a 35% rate — but gave executors the option to elect either the estate tax with full step-up or no estate tax with modified carryover basis. Some very large estates elected the carryover-basis option because the estate tax savings exceeded the future capital gains cost. The provision expired and was not extended.

Current legislative risk: where the step-up stands now

The step-up in basis has appeared as a target in multiple recent federal budget proposals. The most concrete proposal came in President Biden's fiscal year 2023 and 2024 budget requests, which proposed treating death (and gifts) as realization events — meaning unrealized capital gains would be taxed at death at the applicable capital gains rate, with exemptions of $5 million per person ($10 million per married couple) and exclusions for family-owned businesses and farms that remain in family operation.

This is not a carryover basis in the traditional sense — it is a deemed realization at death. The heir would receive a stepped-up basis (equal to the fair market value at death), but the estate would owe capital gains tax on the appreciation. The economic effect on the estate is similar to eliminating the step-up, but the administrative mechanics are different: the tax is assessed at death rather than deferred until the heir sells.

None of these proposals have been enacted. But the 2025 TCJA sunset creates a legislative environment where estate-tax provisions are actively being renegotiated. If the exemption drops from $13.6 million to approximately $7 million per person, Congress may seek revenue offsets that include step-up modification — either as a standalone measure or as part of a broader tax reform package. The step-up is not safe simply because past repeal attempts failed; it is a high-revenue-impact provision that will continue to attract legislative attention.

Assets that already lack the step-up: IRD under IRC section 691

While the debate over the step-up focuses on capital assets like stocks and real estate, several important asset categories already operate under what is effectively a carryover-basis (or worse) regime. Income in respect of a decedent (IRD) under IRC section 691 includes:

• Traditional IRAs, 401(k)s, 403(b)s, and other tax-deferred retirement accounts: The entire balance is taxed as ordinary income to the beneficiary upon withdrawal. There is no basis step-up, no capital gains treatment, and no deferral beyond the applicable distribution period. The heir pays income tax at their marginal ordinary rate — currently up to 37% federal plus applicable state income tax.
• Non-qualified annuities: The gain portion (contract value minus investment in the contract) is taxed as ordinary income to the beneficiary. The original investment (basis) is returned tax-free, but the accumulated earnings carry over as ordinary income — no step-up.
• Deferred compensation (IRC section 409A): Amounts deferred under nonqualified deferred compensation plans are IRD to the beneficiary, taxed as ordinary income when received.
• Installment obligations (IRC section 453): If the decedent sold property on an installment note, the remaining gain recognized on future payments is IRD — the beneficiary who collects the payments recognizes the gain at ordinary income rates.
• Accrued but unpaid income: Salary, bonuses, commissions, and other income earned before death but paid after death is IRD.

The IRC section 691(c) deduction partially offsets the double taxation of IRD assets: when both estate tax and income tax apply to the same asset, the beneficiary can deduct the federal estate tax attributable to the IRD item on their income tax return. This deduction is an itemized deduction (not subject to the 2% floor) and can significantly reduce the effective combined rate — but it only helps estates large enough to actually owe federal estate tax.

The SECURE Act compression: step-up absence meets accelerated distribution

Before the SECURE Act of 2019, non-spouse beneficiaries of inherited IRAs could stretch distributions over their own life expectancy — a 40-year-old heir could spread a $800,000 inherited IRA over 43+ years, taking minimum distributions of roughly $18,600 in year one and allowing the remainder to continue growing tax-deferred. The annual income hit was manageable and rarely pushed the beneficiary into a higher bracket.

The SECURE Act (and SECURE Act 2.0) replaced this with a 10-year rule for most non-spouse, non-eligible designated beneficiaries under IRC section 401(a)(9)(H). The same $800,000 IRA must now be fully distributed within 10 years of the account owner's death. If spread evenly, that is $80,000 per year in additional ordinary income — enough to push many beneficiaries from the 24% bracket into the 32% or 35% bracket.

The interaction is compounding: retirement accounts never received the step-up in basis, and now the income recognition is compressed into a shorter period. For a high-earning beneficiary in a high-tax state — a software engineer in California earning $250,000 and inheriting an $800,000 IRA — the combined federal and state marginal rate on the IRA distributions can exceed 50%. This is the asset class where "step-up basis erosion" is already reality, not a future risk.

Worked example: $4.2 million estate with concentrated stock and inherited IRA

Margaret, age 78, dies in 2026 with the following assets. Her sole heir is her son David, age 52, a physician earning $380,000 per year in Illinois.

• Concentrated stock position (single tech company): $1,800,000 (basis: $120,000)
• Diversified brokerage account: $650,000 (basis: $380,000)
• Primary residence: $720,000 (basis: $195,000)
• Traditional IRA: $850,000 (entirely pre-tax)
• Bank and money market accounts: $180,000
• Total: $4,200,000

Under current law: step-up preserved

Margaret's estate is below the 2026 federal estate tax exemption (approximately $13.6 million if TCJA is extended, or approximately $7 million if it sunsets). Assume for this example that no federal estate tax is owed — the exemption covers the full $4.2 million under either scenario.

The capital assets receive a full step-up under IRC section 1014:

• Concentrated stock: basis steps up from $120,000 to $1,800,000. David sells immediately — zero capital gains tax on $1,680,000 of appreciation.
• Diversified brokerage: basis steps up from $380,000 to $650,000. David sells immediately — zero capital gains tax on $270,000 of appreciation.
• Residence: basis steps up from $195,000 to $720,000. David sells — zero capital gains tax on $525,000 of appreciation.

Total unrealized gains eliminated by the step-up: $2,475,000. At a combined federal and Illinois capital gains rate of approximately 28.4% (20% federal long-term capital gains + 3.8% net investment income tax + 4.95% Illinois flat income tax), the step-up saves David approximately $703,000 in capital gains taxes.

The IRA does not receive a step-up — it is IRD under IRC section 691. David must withdraw the entire $850,000 within 10 years under the SECURE Act ten-year rule. If he spreads withdrawals evenly at $85,000 per year, each withdrawal is taxed as ordinary income on top of his $380,000 physician salary. At a combined federal and Illinois marginal rate of approximately 41% (35% federal + some phase-in toward 37% + 4.95% Illinois), the total income tax on the IRA over 10 years is approximately $348,500.

Under a hypothetical carryover-basis regime

Now assume Congress eliminates the step-up and replaces it with a carryover basis (with a $5 million per-person exemption on deemed realization, consistent with recent proposals). Margaret's total unrealized gains are $2,475,000 — below the $5 million exemption threshold. In this scenario, David would not owe capital gains tax at Margaret's death, but he would inherit the assets with Margaret's original basis:

• Concentrated stock: basis remains $120,000. When David sells at $1,800,000, he owes capital gains tax on $1,680,000 — approximately $477,000 at the 28.4% combined rate.
• Diversified brokerage: basis remains $380,000. Sale at $650,000 triggers $270,000 gain — approximately $76,700 in tax.
• Residence: basis remains $195,000. Sale at $720,000 triggers $525,000 gain — approximately $149,100 in tax (assuming no IRC section 121 exclusion, since David does not use the residence as his primary home).

Total capital gains tax David would owe on inherited assets under a carryover-basis regime: approximately $702,800 — the same $703,000 the step-up currently eliminates, paid when David sells rather than at death.

The IRA treatment is unchanged — it already lacks the step-up. David's total tax burden under a carryover regime: approximately $1,051,300 ($702,800 capital gains + $348,500 IRA income tax), compared to $348,500 under current law. The step-up is worth over $700,000 to this family.

The concentrated stock problem: where step-up erosion hits hardest

The worked example above illustrates a pattern: the step-up's value concentrates in assets with the widest gap between basis and fair market value. Concentrated stock positions — a founder's shares, long-held positions in companies that grew dramatically, employer stock accumulated over a career — often have basis-to-value ratios below 10%. Margaret's tech stock had a basis of $120,000 on $1,800,000 of value — a 6.7% ratio.

For these positions, the step-up eliminates not just the tax but the holding-period lock-in effect. During the decedent's lifetime, selling would trigger an enormous capital gains tax, creating incentive to hold an undiversified position indefinitely. The step-up at death releases this lock-in: the heir inherits at full market value and can immediately diversify without tax consequence. Under a carryover-basis regime, the lock-in effect transfers to the heir — who now has the same tax incentive to hold an undiversified position that the decedent did.

This is not just a tax planning issue — it is an investment risk issue. An heir who inherits $1.8 million in a single stock with a $120,000 basis faces a choice: pay $477,000 in tax to diversify, or continue holding a concentrated position that may decline. Many heirs will choose to hold, perpetuating the concentration risk that sound financial planning would eliminate.

State-level complications

The step-up in basis is a federal provision, but its elimination would have cascading effects at the state level. Most states conform to the federal definition of basis for income tax purposes — meaning a federal shift to carryover basis would automatically increase state capital gains tax on inherited assets in every state that imposes an income tax.

• High-income-tax states (California, New York, New Jersey, Oregon): State capital gains rates of 9-13% would apply on top of federal rates, pushing the combined rate on inherited assets above 35% in many cases.
• States with separate estate or inheritance taxes: In states like Massachusetts (estate tax exemption of approximately $2 million), Oregon (estate tax exemption of $1 million), or Pennsylvania (inheritance tax of 4.5-15%), heirs could face estate or inheritance tax plus capital gains tax on the same appreciation — true double taxation without the offsetting step-up.
• Community property states: Currently, both halves of community property receive a full step-up at the first spouse's death under IRC section 1014(b)(6) — even the surviving spouse's half. This double step-up would be eliminated under a carryover-basis regime, significantly increasing the future tax burden on the surviving spouse who retains the property.

Planning considerations in an uncertain legislative environment

No one can predict whether Congress will modify the step-up in basis. But prudent estate planning acknowledges the risk without overreacting to it:

• Document basis thoroughly. Whether or not the law changes, maintaining records of original purchase prices, capital improvements, reinvested dividends, and prior basis adjustments is essential. If a carryover-basis regime is enacted, estates without documentation will face worst-case basis assumptions. IRS Publication 551 (Basis of Assets) outlines what records to maintain.
• Consider lifetime diversification of concentrated positions. If the step-up is eliminated, the tax benefit of holding appreciated assets until death disappears. Strategies like charitable remainder trusts, exchange funds, or systematic annual sales within lower tax brackets may become more attractive — but they have costs of their own and should not be driven solely by speculative legislative risk.
• Understand which assets already lack the step-up. Traditional IRAs, 401(k)s, non-qualified annuities, and other IRD assets are already taxed at ordinary rates to the beneficiary. The step-up debate is irrelevant for these assets — they are already on the wrong side of it. Planning for these assets (Roth conversions, strategic withdrawal timing, beneficiary designation optimization) produces benefits regardless of what happens to the step-up.
• Monitor the TCJA sunset negotiations. The most likely vehicle for step-up modification is a broader tax reform package tied to the 2025 sunset. If Congress extends the current estate-tax exemption, the step-up is likely preserved. If the exemption is reduced and Congress needs revenue offsets, the step-up becomes a candidate for modification.

The gift vs. bequest asymmetry: IRC section 1015 already uses carryover basis

An often-overlooked feature of current law: lifetime gifts already use carryover basis under IRC section 1015. If a parent gifts stock with a $100,000 basis and a $500,000 fair market value to a child, the child takes the parent's $100,000 basis. If the child sells at $500,000, they owe capital gains tax on $400,000 of gain.

If the same parent holds the stock until death, the child inherits it with a $500,000 step-up basis and owes zero capital gains tax. This asymmetry creates a strong incentive to hold appreciated assets until death rather than gifting them during lifetime — and it is the primary reason estate planners advise against gifting highly appreciated assets while alive.

Under a carryover-basis regime, this asymmetry disappears: both gifts and bequests would carry over the donor/decedent's basis. This would level the playing field between lifetime transfers and testamentary transfers — but at the cost of increasing the tax burden on inherited assets to match the already-higher burden on gifted assets.

Key takeaways

• The step-up in basis under IRC section 1014 resets inherited property to fair market value at the decedent's death, eliminating all unrealized capital gains from the decedent's lifetime. For estates with highly appreciated assets — concentrated stock, long-held real estate, business interests — the step-up can save heirs hundreds of thousands of dollars in capital gains taxes.
• Congress has attempted to replace the step-up with carryover basis twice: in 1976 (retroactively repealed in 1980 due to administrative unworkability) and optionally in 2010 (expired). Both failures were driven by the practical impossibility of determining basis for assets held for decades without adequate records.
• Recent budget proposals have proposed treating death as a realization event rather than imposing a carryover basis — taxing gains at death with exemptions of $5 million per person. Neither approach has been enacted, but the step-up remains a high-revenue-impact target in budget discussions, especially around the 2025 TCJA sunset.
• Several asset classes already lack the step-up: traditional IRAs, 401(k)s, non-qualified annuities, and other income in respect of a decedent (IRD) under IRC section 691 are taxed as ordinary income to the beneficiary. The SECURE Act 2.0 ten-year rule compounds this by compressing distribution into a shorter window.
• The most actionable step regardless of legislative outcome is documentation: maintain thorough records of cost basis, capital improvements, and acquisition dates for all assets. If carryover basis is ever enacted, estates without records will face the worst-case tax outcome.
• Lifetime gifts already use carryover basis under IRC section 1015, creating an asymmetry with bequests that incentivizes holding appreciated assets until death. This asymmetry is a core feature of the step-up — and a core target for reform proposals.