Step-Up Basis at Inheritance for Rental Properties

A rental purchased for $120,000 in 1995, fully depreciated, worth $620,000 at death — the heir's basis is $620,000. Depreciation starts over. The $500,000 of gain and the $87,000 of recapture vanish. This is the single largest tax benefit in the Code for long-held real estate, and most landlords plan around it badly.

The step-up in basis under IRC §1014 is what makes "die with the property" a real tax strategy, not just a punchline. For a landlord who has held property for 20 or 30 years, the unrealized gain and accumulated depreciation can dwarf every other line on the balance sheet. How those numbers reset at death — and how they don't — is worth understanding before estate planning conversations get specific.

What §1014 actually does

When a person dies, property included in their gross estate gets a new basis equal to its fair market value on the date of death (or six months later if the executor elects the alternate valuation date under §2032). This is the "step-up." It applies to virtually all property other than retirement accounts, annuities, and certain income in respect of a decedent.

For a rental property, the step-up has three effects:

1. Embedded gain is eliminated. The difference between the decedent's purchase price (plus capital improvements, minus depreciation taken) and the date-of-death fair market value disappears. If the heir sells the property the next day for $620,000, the gain is zero.
2. Depreciation recapture is eliminated. All the accumulated §1250 depreciation that would have been recaptured on sale at the parent's tax rate is wiped clean. The heir starts fresh.
3. Depreciation restarts on the new basis. The heir allocates the stepped-up basis between land and improvements, then begins a new 27.5-year (residential) or 39-year (non-residential) depreciation schedule on the building portion of the new basis.

This is the mechanic that makes hold-to-death rational for a 70-year-old landlord with a fully depreciated portfolio. Selling triggers tax on every dollar of appreciation and every dollar of recapture. Dying transfers the property to the next generation with all of it forgiven.

A worked example

Maria buys a Phoenix duplex in 1998 for $145,000. She allocates $25,000 to land and $120,000 to the building. Over 27.5 years she takes $120,000 of straight-line depreciation, reducing her adjusted basis on the building to zero. She still owns the land at $25,000. Her total adjusted basis on the property is $25,000.

In 2026, the duplex is worth $610,000. Maria's heir is her daughter Lucia.

Scenario A: Maria sells in 2025.

Scenario B: Maria dies in 2025 owning the property. Lucia inherits.

The step-up is worth $145,000+ of federal tax savings on this single property, plus the future depreciation that resets the clock. Multiply across a portfolio and across federal-plus-state tax exposure and the number gets large fast.

Date of death valuation — and the alternate election

The basis equals FMV on the date of death by default. The executor may elect the alternate valuation date under §2032 — six months after the date of death — but only if the election decreases both the gross estate and the federal estate tax due. For estates well below the federal estate tax exemption (currently in the multi-million dollar range per individual), the alternate election is generally unavailable.

For a rental property, FMV at death usually requires a formal appraisal. The IRS gives wide latitude to executor-obtained appraisals from qualified real estate appraisers. Skipping the appraisal and using a Zestimate or a tax-assessment value is the most common mistake — it creates a basis figure with no defensible documentation, leaving the heir exposed years later when they sell.

Best practice: order a formal appraisal as of the date of death within the first six months. Cost: $400–$1,200 for a residential property. Keep the appraisal report in the permanent file with the estate documents.

Community property: the double step-up

In community property states (AZ, CA, ID, LA, NV, NM, TX, WA, WI — and Alaska and Tennessee with elective treatment), property held as community property between spouses receives a full step-up to FMV on the death of the first spouse, not just a 50% step-up.

The mechanic: under §1014(b)(6), each spouse is treated as owning a half-interest in community property. When one spouse dies, that half steps up. Crucially, the surviving spouse's half also steps up — because community property is treated as fully owned by both spouses for §1014 purposes.

Contrast with joint tenancy in a common-law state:

For long-held rentals in community property states, the basis result on the first death can be dramatic. A couple holding a fully depreciated $700,000 rental as community property — the survivor's new basis is $700,000. Same couple in a common-law state holding as JTWROS — the survivor's new basis is roughly $350,000 plus their original half-share basis.

This is a frequent estate planning fix for couples who moved from a common-law state to a community property state: explicitly converting title to community property can pick up the double step-up at the cost of giving up the certain survivorship protections of JTWROS.

Trusts, LLCs, and the inclusion question

The step-up requires the property to be included in the decedent's gross estate for federal estate tax purposes. This is where well-intentioned estate planning sometimes backfires.

Revocable living trust: Property held in a revocable trust at death is included in the decedent's gross estate. Step-up applies normally. This is the most common and cleanest structure.

Irrevocable trust where the grantor has retained no powers: Property is generally not included in the gross estate. No step-up. The trust beneficiaries take the property at the grantor's basis. This is the major trade-off of irrevocable trusts done for estate-tax avoidance — they remove the property from the estate, which can save estate tax above the exemption, but they also forfeit the basis step-up. For families below the federal estate tax exemption, this is almost always a bad trade.

Grantor trust (intentionally defective): The property is in the grantor's estate for income tax purposes during life but out of the estate for estate tax purposes. Step-up treatment depends on the specific powers retained. Many sophisticated estate structures intentionally trade off step-up for other benefits — get a specialized estate attorney's read.

LLC-owned property: The decedent's membership interest in the LLC is what's stepped up. Whether this flows through to a basis step-up on the underlying property depends on whether the LLC has a §754 election in effect. Without a §754 election (and the associated §743(b) adjustment), the inside basis of the LLC's property does not adjust — only the outside basis of the deceased member's interest does. For a single-member LLC (disregarded entity), this doesn't matter because the LLC is transparent. For a multi-member LLC taxed as a partnership, the §754 election is often crucial.

Planning patterns that actually work

A few practical patterns for landlords thinking about the next generation:

• Hold appreciated property for step-up; sell loss property during life. Tax loss harvesting works during life; step-up resets gains at death. Selling a loss property to a third party during life lets you use the loss; the property only needs to die in your estate to get the step-up benefit.
• Skip the 1031 if death is near. A 1031 exchange defers gain. If you're planning to hold until death anyway, the deferred gain disappears at step-up — so the 1031 was just complexity. For older operators, the question of "exchange or hold" tilts toward hold.
• Order an appraisal at every meaningful family event. Date-of-death appraisals are the most important, but partial valuations during life (gifting, divorce, refinance) build a paper trail that supports later positions.
• In community property states, document community property treatment. A spousal property agreement or community property trust makes the double step-up much harder to challenge.
• Coordinate with the §754 election if you hold through a multi-member partnership. Without it, the inside-basis step-up doesn't happen on the partner's death.
• Watch the federal estate exemption. The exemption has been scheduled to revert in past tax cycles. If you're in the band where estate tax becomes a factor again, the analysis (use exemption now via gifts and trusts, vs. hold for step-up) gets specific to your numbers. Talk to an estate attorney.

FAQ

Does step-up apply to depreciation taken before death? Yes — depreciation recapture for §1250 property disappears at death along with the regular gain. The heir starts a fresh depreciation schedule on the stepped-up basis.

Does the step-up apply to property in an installment sale at death? Generally no. An installment note is income in respect of a decedent (IRD) under §691 and does not receive a basis step-up. The heir continues to recognize gain as principal payments come in. This is a frequent surprise for sellers who used an installment sale to spread tax.

What about state-level basis rules? Most states conform to the federal step-up for state income tax purposes. A few have nuances around community property treatment for non-resident decedents. Check with a state-licensed CPA, especially if the property is in a different state than the decedent's residence.

Does the step-up apply to a 1031 replacement property? Yes. The basis of the replacement property in a §1031 exchange carries the deferred gain during life but resets at death. This is why "swap till you drop" works as a strategy: the exchange defers, then death erases.

What's the basis of property gifted during life vs. inherited? Gifted property carries over the donor's basis (with some adjustments for gift tax paid). Inherited property gets the step-up. The difference can be hundreds of thousands of dollars on a single appreciated rental — a strong argument against gifting appreciated rentals to children during life unless there's a specific reason.

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This isn't tax or estate advice. Step-up rules interact with state law, marital property regimes, and trust structure in complex ways — work with a CPA and an estate attorney before relying on anything here.