What Is Cost Basis?
Cost basis is what you paid for an asset, adjusted for certain events over time. For a stock purchased at $10, the basis is $10 per share. If the company pays a stock dividend or the investor reinvests dividends, the basis adjusts accordingly. When you sell the asset, your taxable gain or loss is the difference between the sale price and your adjusted cost basis.
Accurately tracking basis — especially across decades, dividend reinvestments, and corporate actions — is one of the more tedious aspects of long-term taxable investing. Brokerages are required to report cost basis to the IRS for securities purchased after certain dates (2011 for stocks, 2012 for mutual funds, 2014 for fixed income), but older positions may have no brokerage records and require taxpayer documentation.
Basis can increase over time — for instance, reinvested dividends are treated as additional purchases, each adding to the total basis. Basis can also decrease — return-of-capital distributions, for example, reduce basis and can eventually push it to zero. For real estate, basis includes the original purchase price plus capital improvements (a new roof, an addition) but not routine maintenance.
When an investor receives a gift of securities, the recipient generally inherits the donor's original basis (carried-over basis). This can create a significant embedded gain that the recipient takes on along with the asset. When an investor inherits securities, however, a fundamentally different rule applies — the step-up in basis.
The Step-Up at Death
Under IRC Section 1014, when an asset is inherited, its cost basis is "stepped up" to its fair market value on the date of the decedent's death. All embedded capital gains accumulated during the deceased's lifetime are permanently eliminated for federal income tax purposes.
If a parent bought 1,000 shares of stock at $5 per share and they are worth $150 per share at death, the heir's basis is $150 — not $5. A subsequent sale at $152 produces a taxable gain of only $2 per share. The original $145 per share of appreciation disappears from the income tax system entirely.
The step-up applies to assets included in the decedent's gross estate for estate tax purposes. This generally means assets owned outright by the decedent or held in a revocable living trust. It does not apply to assets held in IRAs or 401(k)s, which pass with their own distribution rules; it does not apply to gifts made during the donor's lifetime; and it does not apply to jointly held property beyond the decedent's share (with some exceptions for community property states).
In community property states, both halves of jointly owned community property receive a stepped-up basis at the death of either spouse — a significantly more generous treatment than in common-law states, where only the decedent's half steps up.
The Scale of the Benefit
The Joint Committee on Taxation estimates the step-up in basis costs the federal government approximately $40–50 billion in annual revenue, making it one of the largest tax expenditures in the code. For wealthy families with highly appreciated assets — a founder's stock position, a family farm, commercial real estate purchased decades ago — the step-up is often the most valuable tax benefit available.
A $10 million portfolio with a $1 million original basis generates a capital gain of $9 million if sold during life; at the 23.8% top federal rate (20% plus 3.8% NIIT), the tax would be approximately $2.1 million. Inherited, the portfolio generates zero capital gains tax. This provision, combined with the estate tax exemption (over $13 million per person as of 2024), means that very large concentrations of wealth can pass across generations with minimal income tax consequence.
The benefit scales with both the size of the gain and the taxpayer's marginal rate. For a founder who acquired stock at near-zero basis — a common outcome for company founders whose initial stock is nearly worthless — the step-up effectively eliminates the capital gains tax on an entire lifetime of wealth creation. This is not an accidental feature of the code; it reflects a longstanding legislative choice to treat death as a non-recognition event rather than a deemed sale.
The step-up also applies to assets that have declined in value — the "step-down" — though heirs of depreciated assets rarely advertise this aspect of the rule.
Planning Implications
The step-up in basis creates a simple but powerful planning rule for investors with highly appreciated positions: do not sell if you can avoid it. Instead, hold appreciated assets until death, borrow against them if cash is needed (loans are not taxable events), and donate them to charity rather than selling.
Donors who contribute appreciated securities directly to charity — or to a Donor-Advised Fund — avoid the capital gains tax entirely and deduct the full fair market value of the securities. This makes donating appreciated securities significantly more efficient than donating cash: donating $10,000 of stock with a $2,000 basis saves both the $1,200–$1,900 in capital gains tax that would have been owed on a sale and generates the same charitable deduction as a $10,000 cash gift.
Critics argue the step-up is one of the most regressive provisions in the tax code because it disproportionately benefits the wealthiest estates — ordinary wage earners accumulate little in the way of highly appreciated taxable assets relative to business owners, investors, and real estate holders. It has survived repeated legislative challenges, including proposals by Presidents Obama and Biden to tax gains at death or eliminate the step-up entirely.
The persistence of the step-up means that the optimal hold-versus-sell decision for appreciated assets often turns on life expectancy and estate planning considerations, not just investment merits. A financial plan that ignores the step-up can lead to premature realisation of gains that would have been tax-free had the investor simply waited.