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BOB MADE A very expensive tax mistake. Doctors told Bob that he only has a year to live… What did Bob do?
He decided to gift a house to his only son before passing away. The house is worth $2,000,000 that he bought back in 1970 for $50,000 in an expensive suburb of California.
The son decided to sell the house and paid about $430,000 in federal taxes.
$430,000 that could have been $0 instead…
How?
When you gift a property to someone, they receive a “carryover basis.” It basically means the same price the original owner purchased it for.
The basis of that house was $50,000, so the son had to pay capital gains tax on the difference between the $2 million sale price and the basis, at rates reaching up to 23.8% on the top portion of the gain. But this is where a step-up in basis could come into play.
Assets such as a house or shares held in a brokerage account, when owned inside an estate rather than an irrevocable trust, receive a step-up in basis to their fair market value (FMV) at the time of the decedent’s death, per IRC Section 1014. In our case, if Bob held that house in his own name, passed away, and his son received the house, he would’ve gotten a step-up in basis to the current value, or $2M.
At the time of the sale, if sold for $2M, he would pay $0 in federal taxes, though state tax might still apply. That’s about $430,000 of “savings.”
“But who cares, Bob is dead anyways?”
While true, many parents still want to make sure their children don’t have to pay half a million in taxes. They want their children to enjoy the fruits of their hard labor.
Specifics
The step-up in basis can be a bit nuanced, depending on how the assets are held and titled.
First, the step-up in basis typically adjusts to the market value, unless an election is made to use the value six months after the date of death, subject to certain rules.
The step-up in basis also doesn’t apply to assets held in an irrevocable trust , though we will cover some strategies for that later, or to assets held in qualified retirement accounts, such as IRAs and 401(k)s.
In a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), the basis steps up whenever a spouse dies. You will typically need to complete a form to receive this step-up in a brokerage account.
For assets held in joint tenancy, the step-up applies only to the deceased partner’s share. For example, Bob and Jenice have a house worth $300,000 with a $50,000 basis. After Bob passes away, Jenice will have a $175,000 basis in the house, calculated as ($300,000 minus $50,000) divided by two, plus $50,000.
There are also two additional things to keep in mind:
1. Living on the right assets
Bob, age 75, has two accounts: a traditional 401(k) worth $500,000 and a brokerage account worth $500,000. Bob’s diagnosis isn’t good.
From a tax-planning perspective, it might make a lot more sense to withdraw, say, $50,000 a year from the 401(k) to live on, $20,000 of which would be required minimum distributions (RMDs), and pass down the brokerage account to his beneficiaries.
This is because the brokerage account likely has a lot of gains. Bob bought many stocks in his 30s and 40s that could be stepped up now. But a more in-depth analysis might be needed if Bob has a lot of income and is in a high marginal tax bracket.
2. Selling the right lots
Say Bob has a $500,000 brokerage account. Some of the stock purchases have a low basis, meaning a lot of capital gains, and some have a high basis, meaning fewer capital gains.
It’s best to sell the high-basis stocks, which come with a lower capital gains tax, and pass down the low-basis stocks to the beneficiaries.
Planning matters. These mistakes can cost thousands of dollars in unnecessary taxes. As always, make sure to consult a licensed CPA or estate attorney with your unique circumstances.
Bogdan Sheremeta is a licensed CPA based in Illinois with experience at Deloitte and a Fortune 200 multinational. 
This stepped up basis also applies to charitable giving I believe. So appreciated securities and real estate make great charitable gifts, before or after one passes. And the tax benefit can be substantial for the donor.
Woohoo,
This is so on time for me as I am seeing my estate lawyer on Aug 3 to ask questions and revise anything that needs to be.
THANK YOU Bogdan
I keep hearing about how boomers are hoarding houses. Maybe if boomers could sell their houses without having to pay a huge amount in capital gains, they’d be more willing to move. The gains are going to be stepped up anyhow if they hold on to the property until they die, so why not give them the option to sell tax free a few years earlier?
Or maybe just index the capital gain exclusion for inflation.
Cammer, Very interesting you mention this.
A tenant I have mentioned several homes around his that one fellow owns, but only one is rented out.
This fellow seems to have different ideas of what to do with his property.
Bob also paid one helluva gift tax …
Great article Bogdan, thanks for sharing it!
The section on living off the right assets is a part that really drew my focus. Choosing which account funds retirement spending is a decision people make on autopilot, and it quietly determines how much basis their kids inherit.
One companion rule that pairs with your article, and seems to catch surviving spouses: The home sale exclusion has a clock on it. A widow or widower who hasn’t remarried can claim the full $500,000 exclusion instead of $250,000, but only if the home sells within two years of the spouse’s death. After that it drops to $250,000 permanently.
What strikes me is the contrast with the step-up you describe. The step-up arrives on its own, automatically, with nothing required of anyone. The extra $250,000 of exclusion has to be used before a deadline nobody sends a reminder about.
Two years also happens to be a very short window for someone who is grieving and deciding whether to stay in the house.
The step-up sets the basis. This one decides how much of what’s left gets taxed. Worth knowing they run on different clocks
I had a few thoughts after reading your article.
California law allows for a revocable transfer on death deed that lets the owner(s) name a beneficiary in the deed to receive residential real estate without probate so adding that provision to a deed during life could both transfer the property at Bob’s death and give his son a step-up in tax basis. Often the Bob’s of the world reason for such a gift was concern about headaches in the probate process that a TOD deed could cure. I wish my state law allowed TOD deeds but alas my state does not.
Your article does not mention if Bob had a spouse who predeceased him. If so, since California is a community property state Bob would have gotten a full step-up in basis to the FMV at his spouse’s DOD rather than the original $50K purchase price in 1970 assuming the property was jointly owned.
Good suggestion about planning to sell the high cost investments rather than low cost ones to minimize the tax hit. When the government started the mandatory basis reporting for investment sales starting in 2011 for stock and 2012 for mutual funds many brokers instituted default basis tracking choice methods to report sale basis that may now make choosing which lots of the same investment that were sold harder for the account owner to specify. I know for my Vanguard account the default method for mutual funds is average cost and the default method for ETFs is first in first out. Once part of a mutual fund in a taxable account is sold with basis determined using average cost method then all of the same remaining investment in that specific mutual fund existing on the date of the sale is determined under the average cost method. You can typically choose to change your cost method but only for future share purchases. Moral of the story is to choose the method to track the tax basis of your investment carefully with the best time being when you establish your taxable brokerage account and/or specific investment and certainly no later than before any of that investment is sold. Different brokers may have different default methods.
The mandatory basis reporting of investment sales was primarily created to give the IRS accurate and consistently determined basis information from third parties. My experience after the mandatory basis reporting rules went into effect was that those of us who prepared returns were grateful that we no longer had to track tax basis or redetermine basis from old broker statements. When you are unable to determine tax basis of investments sold the taxing authorities often assume the basis is zero. If your current broker has not held your investments since purchase a good practice is looking at your year end tax statement (1099-B) to see if any sales have basis of zero, NA or any amount that does not seem reasonable like a missing a step-up in tax basis when appropriate.
Thanks for the article Bogdan.
First of all, thanks to Bogdan for an excellent reminder.
I spent an hour with Perplexity this morning after reading Bogdan, before I read your comments. I have a taxable Vanguard account and your notes reinforce what I learnt from that research. Thank you!
I have a mutual fund in my taxable, and planning to take an in-kind RMD distribution next year. I am thinking it would be better to change my cost basis from average to specific lots. This is to enable cashing the new RMD proceeds when I need to, and reduce the capital gains hit and perhaps leave the current shares to spouse.
If you do not currently hold any of that specific mutual fund that you are going to distribute from your regular IRA as a in-kind RMD then you should be able to then elect the specific lots method after distribution as an in-kind distribution of a mutual fund from an IRA for an RMD as the RMD does reset the acquisition date and the cost basis in the taxable account for the distributed shares. It is unclear to me the purpose is for your in-kind distribution rather than cash from your settlement fund.
If I was expecting to spend my RMD in distributed equities shares I would choose to turn off the dividend reinvestment option in my taxable brokerage account to lower the number of lots I had to keep track of to keep my paperwork at a minimum.
If I was sure I was going to spend my full RMD I would likely just take the distribution in cash. I prefer for my equities in a taxable account to produce long term capital gains and for any dividends in the taxable account to be 100% qualified so that both would be taxed at lower capital gains rates.
A quick search indicates, as an example, that at 6/30/26 the Vanguard ETF VOO has an embedded gain of 29% and a P/E over 27 so I am concerned that VOO or your mutual fund could kick off capital gains at the fund level if we have a major market correction before the end of the 2026 year. I am less worried about such embedded gains in my traditional and Roth IRAs as they have no immediate tax consequences. I know I have to take risk for the expected long term higher rewards of holding equities so I avoid holding equities in taxable if I do not think I will hold them for long term, and at age 75 I do not know how long that will be.
Best, Bill
Thank you Bill!
Very good advice. I have held VFIAX in my taxable for long, and am trying to avoid these capital gains affecting my current tax year. Perhaps, I should just cash the RMD into my settlement fund and leave the shares to heirs.
And I never thought of dividend reinvestment affecting short/long term capital gain. That is very insightful. Thanks.
Thanks Bogdan for another important article. It seems no matter how well I think I know the rule, it always has nuances. You for sure have helped many understand how to keep taxes to a minimum. Nice work.
Community Property is a very important concept in the states where it is the law. Unfortunately, to gain the benefits a home must show this in the recorded title. And, in some states there may be nuances. Our home in WA shows our names and Community Property. Our AZ home shows our names and then Community Property Right of Survivorship. Generally, this is the kind of thing that your lawyer will examine when you update your wills etc.
Bogdan, thanks for a great article. I’m aware of a few cases where complex family dynamics lead to what would seem to be bad decisions. I have a friend and colleague who grew up on her family’s farm in western Pennsylvania. She had 5 siblings. All but one sibling left the farm and pursued successful careers. She and her siblings found out after the fact, that the sibling who remained on the farm had convinced the aging parents to gift the majority of the land to him and wife, effectively disinheriting my friend and the other siblings. The parents may have felt that their action was justified because the son who remained was taking care of them and the farm and deserved it. The siblings who left didn’t quite see it that way.
I also have a friend who, in her 80s, gifted her 2 sons her highly appreciated beach house, despite advice to the contrary. She passed away a few years later. The sons don’t appear to be planning to sell anytime soon, but I’m still not sure why she made the gift. There were some interesting family dynamics that may have caused the sons to fear their mother would disinherit them, and they pressured her to gift the home before she passed to prevent that.
Hi Rick,
I left the farm and state when I was just out of high school. My Dad sold officially the farm to the youngest son decades later, me and my siblings knew this so….
we make our own bed is my feeling on this stuff.
Back in 2023 I bought and read the 4th edition re-release of “Poor Charlie’s Almanac” about Charles Munger and his often blunt and contrarian views on life’s decisions.
On 11/10/2024 Adam Grossman’s article titled No Perfect Answers was published on Humble Dollar where Adam’s artitcle about Mr. Munger started as follows-
BEFORE HE DIED LAST year at age 99, a friend asked Charlie Munger if he planned to leave his considerable wealth to his children. Wouldn’t it impact their work ethic, his friend asked?
“Of course, it will,” Munger replied.” “But you still have to do it.”
“Why?” his friend asked.
“Because if you don’t give them the money, they’ll hate you.”
Both Adam’s article and the book have influenced my past thinking and actions of what I am doing in regard to my future death and taxes. The content of Rick’s comment reminded me of the need for me to keep thinking about these topics.
Rick, these experiences illustrate why an attorney once told me that the probate process is like divorce court for siblings.
Great information, Bogdan. Tax planning is so important, and often complicated. Decisions made in ignorance can be costly. And, unlike the stock and bond markets, it’s one area of personal finance where we have control.