Stepped-up basis
The tax code of the United States holds that when a person receives an asset from a giver after the benefactor dies, the asset receives a stepped-up basis, which is its market value at the time the benefactor dies. A stepped-up basis can be higher than the before-death cost basis, which is the benefactor's purchase price for the asset, adjusted for improvements or losses. Because taxable capital-gain income is the selling price minus the basis, a high stepped-up basis can greatly reduce the beneficiary's taxable capital-gain income if the beneficiary sells the inherited asset.
General rule
Under IRC § 1014, which applies to an asset that a person receives from a giver after the benefactor dies, the general rule is that the beneficiary's basis equals the fair market value of the asset at the time the benefactor dies. This can result in a stepped-up basis or a stepped-down basis. An example of a stepped-up basis: If Benefactor owned a home that Benefactor purchased for $35,000, then Benefactor's basis in the home would be equal to its purchase price, $35,000, assuming no adjustments under IRC § 1016, which allows for increases in basis such as home improvements, or decreases in basis such as unrepaired windstorm damage. Continuing the example, the fair market value of Benefactor's home was $100,000 on the day Benefactor died. After Beneficiary inherits the home from Benefactor, Beneficiary's basis in the home is that fair market value, $100,000. In contrast, if Benefactor gives the home to Beneficiary before Benefactor dies, then Beneficiary receives a carryover basis, which is equal to the Benefactor's purchase price for the home, $35,000, again assuming no adjustments under IRC § 1016.Simplified Example
"Basis" is generally the amount a taxpayer has invested in an asset. Thus, in the very simple case, if a taxpayer buys a house for $35,000, his "basis" is $35,000."Gain", in the very simple case, is the amount a taxpayer receives when a taxpayer disposes of an asset, minus the taxpayer's basis in the asset. Thus, if a taxpayer sold the house above for $100,000, the taxpayer's gain would be $65,000, if we ignore complicating factors for purposes of this general example.
Normally, when someone receives an asset from a taxpayer before he dies, the person who receives the asset keeps the same basis in the asset that the taxpayer, the donor, had. For example, if a taxpayer's sister Mary were to receive this house from the taxpayer before he dies, then her basis in the house would also be $35,000, no matter what the fair market value of the house was on the date of the gift. Therefore, if the taxpayer's sister were to sell the house for $100,000, she would generally need to pay income tax on the $65,000 of capital-gain income.
However, in the case of a beneficiary who receives an asset from a benefactor after the benefactor's death, the beneficiary's basis in the asset is "stepped up" to the FMV on the date of the death. For example: If, on the date of a taxpayer's death, he had a basis of $35,000 in the house and the house's FMV was $100,000, and the taxpayer's sister received the house from the taxpayer after his death, then her stepped-up basis would be $100,000, not $35,000. Therefore, if the taxpayer's sister were to sell the house for $100,000, she would not have to pay any income tax because the sales price minus her stepped-up basis would be a capital-gain income of zero.
See the explanation under "Rationale for stepped-up basis" for an explanation of why the Tax Code would do this.