Where you hold title — and where you live — determines whether one spouse’s death wipes out a lifetime of deferred tax liability or merely reduces it by half.
What Stepped-Up Basis Actually Does
IRC Section 1014 resets the basis of inherited property to its fair market value as of the date of death. That single rule is what converts decades of tax-deferred gains into tax-free wealth for heirs. But for married couples, the benefit is not automatic across the board — it depends entirely on how title is held and which state the property sits in.
The Joint Tenancy Problem
When a husband and wife hold real estate as joint tenants and one spouse dies, the survivor inherits the deceased spouse’s half and that half receives a stepped-up basis. The survivor’s own half, however, retains its original cost basis — every dollar of depreciation taken and every dollar of appreciation built up over the years remains embedded and fully taxable on a future sale.
Consider the math: a couple purchased a duplex for $295,000, spent $30,000 improving it, and took $50,000 in depreciation over five years, leaving an adjusted basis of $275,000. If the property is now worth $700,000 and one spouse dies, the surviving joint tenant steps up only the deceased’s $350,000 share to fair market value. The survivor’s $350,000 share still carries its old, depreciated basis. A sale after the death would produce a taxable gain on that surviving share — gain the couple spent years deferring through 1031 exchanges.
The Community Property Advantage
In the nine community property states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin — the entire property receives a stepped-up basis when one spouse dies, not just the deceased’s half. Both halves reset to fair market value on the date of death. Alaska gives married couples the option to achieve the same result by opting in to a community property arrangement.
That difference is enormous in practice. The same couple in a community property state who held that same $700,000 duplex could pass it to heirs — or allow the surviving spouse to sell it — with a basis equal to current fair market value. The capital gains accumulated over a lifetime of exchanges, and the depreciation recapture that would otherwise follow the property, disappear entirely.
Holding Title and Entity Structure
The full step-up is cleanest when property is held in an individual’s name. When a partnership or LLC owns the property, the entity can make an IRC Section 754 election upon the death of a partner or member — that election produces a stepped-up basis for the beneficiary’s interest in the property. It is still available, but it requires an affirmative election and adds complexity.
Corporations are a different matter. When a shareholder in a corporation dies, the property inside the corporation does not receive a stepped-up basis. The corporate structure blocks the benefit entirely — one more reason that partnerships and LLCs are the preferred entities for real estate held outside an individual’s name.
The Lifetime Strategy
Stepped-up basis is only available for inherited property, never for purchased or gifted property — a gift transfers the donor’s existing basis to the recipient, with no reset. That means the strategy requires holding the property until death, using Section 1031 exchanges to defer gains along the way. Keep exchanging, and at death your heirs take the property at stepped-up basis — the deferred tax never comes due.
Pairing Section 1031 with the stepped-up basis rules, and adding Section 121 for a primary residence, forms the ultimate lifetime investing plan. Community property titling is not a technicality — it is the difference between a partial erasure of deferred tax and a complete one.