Gifting Property Before Death Can Trigger Massive, Avoidable Tax Bill

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A real planning error illustrates what step-up in basis means and why it matters: a father diagnosed with a terminal illness gifted his son a California house worth $2 million that he had bought in 1970 for $50,000. Because the gift transferred the original $50,000 cost basis to the son, the son owed roughly $430,000 in federal capital gains tax when he sold. Had the father simply held the house in his own name until death, the son would have inherited it with the basis reset to $2 million under IRC Section 1014 — the step-up in basis rule — and owed $0 in federal tax on the sale. The lesson: transferring appreciated property as a gift while alive often costs far more in taxes than leaving it to heirs through an estate.

Author Bogdan Sheremeta outlines several related nuances. The step-up does not apply to assets inside an irrevocable trust (a trust whose terms generally cannot be changed once signed) or to retirement accounts such as IRAs and 401(k)s. In community property states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin — the full basis steps up when either spouse dies. For assets held in joint tenancy, only the deceased person's share gets the step-up. Two additional strategies: someone with both a 401(k) and a taxable brokerage account who is drawing down savings may be better off spending the 401(k) first and leaving the brokerage account to heirs, since brokerage gains can be eliminated by the step-up at death. Similarly, when selling some positions in a brokerage account, it is better to sell the high-basis lots now and preserve the low-basis lots to pass on, where the step-up will eliminate the embedded gain.