Capital Gains Taxes and the Step-Up in Basis

Consider a scenario that plays out across Texas every day. An executor is selling a home that the decedent purchased decades ago for $50,000. Today, that home is worth $450,000. If there were no step-up in basis, the estate — or the heirs — would owe federal capital gains tax on $400,000 of appreciation. At the maximum federal long-term capital gains rate of 20%, that's an $80,000 tax bill — before you account for the 3.8% Net Investment Income Tax that applies to higher-income filers.

With the step-up in basis, the tax bill could be zero.

This is not a loophole or a special benefit for the wealthy. It is a foundational principle of the federal tax code, built into the Internal Revenue Code for decades. Understanding how it works is one of the most consequential things an executor or heir can do — not just for tax planning, but for making smart decisions about whether to sell immediately, hold the property, or transfer it.

Under IRC Section 1014, when a person dies, the tax basis of their appreciated assets — including real estate — is "stepped up" to the fair market value as of the date of death.¹ The personal representative can alternatively elect to use the alternative valuation date, which is six months after the date of death, if doing so decreases both the gross estate value and the estate tax liability.²

In plain language: tax basis is the starting point from which capital gains (or losses) are measured when an asset is sold. If you buy a house for $100,000, your basis is $100,000. If you later sell it for $150,000, you have a $50,000 capital gain — and you pay tax on that $50,000. The step-up in basis essentially resets the starting line to the property's value on the day the owner died, regardless of what the owner originally paid.

This means that all of the appreciation that occurred during the decedent's lifetime — potentially decades of market gains — is never taxed. The tax obligation begins only from the new stepped-up value forward.

Let's walk through a concrete example using Texas Hill Country numbers, where property values have appreciated substantially over the past three decades.

Scenario A: Immediate Sale at Date-of-Death Value

If the heir sells the property immediately for $500,000, the sale price equals the stepped-up basis. The capital gains tax is zero. The $380,000 of appreciation that occurred during the decedent's lifetime is never taxed.

Scenario B: Sale Six Months Later

If the heir waits six months and sells the property for $520,000, the capital gains tax applies only to the $20,000 of post-death appreciation — not the $380,000 of pre-death appreciation. At a 15% federal capital gains rate, the tax bill is approximately $3,000. Without the step-up, that same $520,000 sale would have produced a taxable gain of $400,000 (or more, depending on the basis calculation), potentially resulting in a tax bill of $60,000 to $80,000+.

Scenario C: Sale a Year Later

If the heir holds the property for a year and sells for $540,000, the taxable gain is $40,000 ($540,000 sale price minus $500,000 stepped-up basis). The lifetime appreciation remains untaxed. And because inherited property is automatically treated as a long-term capital gain regardless of how long the heir holds it, the favorable long-term capital gains rates apply from day one.³

The step-up in basis has special rules for jointly owned property, and these are particularly important for married couples — a common scenario in Texas estate planning.

Tenancy by the Entirety or Joint Tenancy with Right of Survivorship

For jointly owned property between spouses (tenancy by the entirety or joint tenancy with right of survivorship), each spouse's share gets a step-up in basis at their respective date of death. If one spouse dies, the surviving spouse's half retains its original basis, while the deceased spouse's half receives a step-up to fair market value at the date of death.¹

For example, if a couple purchased a home for $200,000 (each spouse's basis = $100,000) and it is worth $500,000 at the first spouse's death, the surviving spouse's basis in the decedent's half steps up to $250,000 (half of $500,000). The surviving spouse now has a combined basis of $350,000 ($100,000 original + $250,000 stepped-up).

Community Property

Texas is a community property state, and this matters significantly for the step-up in basis. Under IRC Section 1014(b)(6), in community property states, both halves of community property receive a step-up in basis when the first spouse dies — provided the property meets the community property requirements.⁴

This means the surviving spouse's half of a community property home also steps up to the date-of-death value — effectively doubling the step-up compared to common-law property states. This is one of the most valuable tax benefits of community property ownership and is worth discussing with a CPA or tax attorney as part of the estate plan.

Not every inherited property is sold immediately. In many families, heirs decide to keep the property — either because they want to live in it, rent it out, or hold it as an investment. The step-up in basis benefits these heirs as well, and in some cases even more significantly.

Here's how it works: when the heir eventually sells the property — whether it's next year or ten years from now — the tax gain is measured from the stepped-up basis at the date of death, not the decedent's original purchase price. All appreciation that occurred before the decedent's death is never taxed, no matter how long the heir holds the property.

If the heir rents the property for several years and it appreciates during that time, only the post-death appreciation is subject to capital gains tax. And because inherited property is treated as a long-term capital gain regardless of holding period, the favorable federal long-term capital gains rates (0%, 15%, or 20%, depending on the heir's income) apply from the moment of inheritance.³

Additionally, if the heir eventually makes the inherited property their primary residence and then sells it, they may be eligible for the Section 121 exclusion — up to $250,000 (single) or $500,000 (married filing jointly) in capital gains tax avoidance — provided they meet the two-year ownership and residency requirements.⁵

In Texas, many estates sell the real property during the probate process — before the estate has been formally distributed to the heirs. This is common, especially when the estate needs liquidity to pay debts, taxes, or expenses. The step-up in basis still applies.

When the personal representative (executor or administrator) sells the property during probate, the estate itself reports the gain on the estate's income tax return (IRS Form 1041). The basis is stepped up at the date of death, regardless of when the sale actually closes.⁶ This is true whether the sale occurs weeks after death or months into the probate process.

If the property is sold at or near the date-of-death value, the estate's taxable gain is minimal or zero — just as it would be if the heirs sold after distribution. The personal representative should coordinate with the estate's CPA to ensure the gain is properly reported and the stepped-up basis is correctly applied.

One important nuance: if the personal representative elects the alternative valuation date (six months after death), and the property is sold before that date, the basis depends on whether the property was on hand at the alternative valuation date. This is a technical area that requires CPA guidance.²

The step-up in basis is a powerful benefit, but the rules have nuances that can affect individual situations. This page provides educational guidance — not tax advice. Here are the key caveats that executors and heirs should be aware of:

• Alternate valuation date. The personal representative can elect to value the estate assets six months after the date of death instead of the date of death itself, but only if doing so reduces both the gross estate value and the estate tax liability. This election is made on IRS Form 706.²
• Generation-skipping transfer tax (GSTT). If the property passes to grandchildren or more remote descendants, the GSTT may apply independently of the step-up in basis. This requires separate analysis.⁷
• Federal estate tax threshold. For 2026, the federal estate tax exemption is expected to be significantly lower than its current level due to the scheduled sunset of the Tax Cuts and Jobs Act provisions. Estates exceeding the exemption threshold may owe federal estate tax, which is separate from capital gains tax.⁸
• State inheritance or estate tax. Texas does not impose a state income tax, estate tax, or inheritance tax. However, heirs receiving property from estates in other states should check whether those states impose such taxes.
• Depreciation recapture. If the decedent used the property as a rental and claimed depreciation, the stepped-up basis eliminates recapture of depreciation that accrued before death. Any depreciation claimed after the heir takes ownership may be subject to recapture on sale.⁹
• Gifting before death. If the property was gifted rather than inherited, the step-up does not apply. A lifetime gift uses the donor's basis (carryover basis), not the fair market value. This is one of the key differences between gifting and inheriting property.¹