© 2026 Wealth Care Lawyer — Klaus Gottlieb, Esq. Serving the California Central Coast.
Jurisdiction: Federal; California
Primary Statutes: IRC §§ 1001, 1014, 1014(b)(6), 1014(e), 1015, 1015(d), 1223(2), 691; Treas. Reg. §§ 1.1014-1 through 1.1014-6; 1.1015-1
Last Reviewed: March 2026
Category: Estate Planning — Income Tax; Basis Planning
Two sets of rules govern the income tax basis of property transferred between individuals. Which rule applies depends entirely on whether the transfer is a gift during the donor’s lifetime or a transfer at death.
For gifts, the recipient generally takes the donor’s original basis — carryover basis. If the asset has declined in value below the donor’s basis at the time of the gift, a split dual basis applies: the donee uses the donor’s basis to measure gains but only the lower fair market value to measure losses, with a no-recognition zone in between. Built-in losses cannot be transferred by gift.
For inherited property, the recipient takes a basis equal to the asset’s fair market value on the date of the decedent’s death — a stepped-up (or stepped-down) basis that eliminates all gain or loss that accrued during the decedent’s lifetime. For California community property, both the decedent’s half and the surviving spouse’s half receive a full stepped-up basis at the first death under IRC § 1014(b)(6) — a significant advantage over separate property.
Two critical exceptions to the step-up rule are frequently missed in practice: (1) the § 1014(e) one-year anti-abuse rule, which denies the step-up for appreciated property gifted to a terminally ill person and inherited back within a year; and (2) income in respect of a decedent (IRD) under § 691, which excludes retirement accounts, deferred compensation, and accrued income items from the step-up entirely.
The most important practical implication flows directly from these rules: gifting low-basis appreciated property to someone who will likely predecease the donor, or who will hold the asset until death, produces a worse income tax outcome than simply retaining the asset and allowing it to pass through the estate with a stepped-up basis. Under the post-OBBBA exemption of $15 million per person, most California estates will not owe federal estate tax, which means the step-up is obtainable at no estate tax cost. The case for gifting low-basis appreciated assets has never been weaker for most clients.
When a donor makes a gift of property that has appreciated in value (fair market value exceeds the donor’s adjusted basis at the time of the gift), the donee takes the donor’s adjusted basis. IRC § 1015(a). The donee inherits not just the asset but the donor’s embedded gain. When the donee later sells the asset, the gain is measured from the donor’s original basis, not from the value at the time of the gift.
Example. Donor purchased stock for $20,000. At the time of the gift, the stock is worth $80,000. Donor gives the stock to Donee. Donee’s basis is $20,000. If Donee later sells for $95,000, Donee recognizes a $75,000 gain.
The embedded gain is not forgiven by the gift — it is transferred. This is the defining characteristic of carryover basis and the principal income tax cost of lifetime giving.
If the fair market value of the gifted asset is less than the donor’s adjusted basis at the time of the gift — meaning the asset has declined in value — the donee takes a split basis: different basis depending on whether the later sale produces a gain or a loss.
The purpose is to prevent the transfer of built-in tax losses by gift. The donor could not deduct the loss herself without selling the asset. Allowing the donee to step into the donor’s basis and immediately recognize the loss would create deductions that were never available to either party before the transfer.
Example — the no-recognition zone. Donor’s adjusted basis: $100. Fair market value at time of gift: $70. Donee later sells for $85. Sale price is between FMV ($70) and donor’s basis ($100) — no gain or loss recognized. If Donee sells for $60, loss is $10 (not $40) — measured from FMV of $70. If Donee sells for $110, gain is $10 — measured from donor’s basis of $100.
⚠️ CRITICAL PLANNING IMPLICATION — LOSS ASSETS: A donor who holds an asset worth less than its basis should sell the asset before gifting it, recognize the loss on the donor’s own return, and gift the cash proceeds. Gifting the loss asset transfers the asset but forfeits the loss — under the dual basis rule, the donee’s loss basis is capped at the depressed FMV, so all of the pre-gift decline in value is permanently lost for tax purposes as soon as the gift is made.
For purposes of determining whether gain on a later sale is long-term or short-term, the donee’s holding period includes the donor’s holding period — the periods tack. IRC § 1223(2). This rule applies only where the donee’s basis is determined by reference to the donor’s basis (i.e., carryover basis for gains). Where the donee’s basis is determined by fair market value (the loss side of the dual basis rule), the donee’s holding period starts fresh on the date of the gift.
When the donor pays gift tax on the transfer, the donee’s carryover basis may be increased by a portion of the gift tax paid. IRC § 1015(d). This prevents double taxation: the donor pays gift tax on the transfer; without the adjustment, the donee would then pay capital gains tax on the full appreciation, including the portion already taxed by the gift tax.
The adjustment is not simply “add the gift tax paid to basis.” The formula limits the increase to the portion of the gift tax attributable to the net appreciation in the asset:
Basis increase = Gift tax paid × (Net appreciation ÷ FMV at time of gift)
Where net appreciation = FMV at time of gift − Donor’s adjusted basis.
The adjusted basis after the gift tax increase cannot exceed the FMV of the property at the time of the gift. This ceiling prevents the adjustment from converting a gain asset into a loss asset.
Example. Donor’s adjusted basis: $40,000. FMV at time of gift: $100,000. Net appreciation: $60,000. Gift tax paid: $30,000. Basis increase = $30,000 × ($60,000 ÷ $100,000) = $18,000. Donee’s adjusted basis = $40,000 + $18,000 = $58,000.
📌 PLANNING NOTE: The § 1015(d) adjustment matters only when the donor actually pays gift tax — which, under the current $15 million lifetime exclusion, is uncommon for most clients. For annual exclusion gifts and transfers within the lifetime exemption, no gift tax is paid and no adjustment is available. The adjustment is most relevant for very large inter vivos transfers by donors who have exhausted their exclusions.
A beneficiary who acquires property from a decedent takes a basis equal to the fair market value of the property on the date of the decedent’s death. IRC § 1014(a)(1). All gain or loss that accrued during the decedent’s lifetime is permanently eliminated — neither the decedent nor the beneficiary ever pays income tax on it. If the asset has appreciated, the basis steps up to FMV. If it has declined, the basis steps down. Both directions are mechanically identical; the step-up terminology simply reflects that most long-held assets appreciate over time.
The practical consequence: a beneficiary who sells inherited property immediately after receiving it (at a price equal to the date-of-death FMV) recognizes no gain. The decedent’s entire lifetime appreciation is forgiven by operation of § 1014.
📌 PLANNING NOTE — THE CORE IMPLICATION: A client who holds a low-basis appreciated asset can either (a) give it away during life and transfer the embedded gain to the recipient (carryover basis), or (b) hold it until death and have the gain permanently eliminated (stepped-up basis). For most clients under the post-OBBBA $15 million exemption who will not owe federal estate tax, option (b) is categorically superior from an income tax standpoint. The estate tax cost of retaining the asset is zero; the income tax cost of gifting it is the capital gains tax on the embedded gain, paid eventually by the donee.
If the decedent’s estate is subject to federal estate tax, the executor may elect to value the estate as of six months after the date of death rather than the date of death itself. IRC § 2032. The election is only available if it would reduce both the gross estate value and the net estate tax liability; it is not available to produce a higher basis without a corresponding estate tax reduction. If the alternate valuation date is elected, the beneficiary’s basis in property distributed or sold before the alternate valuation date is the value on the date of distribution or sale, not the date of death.
For most California clients whose estates are below the $15 million exemption, this election is not available — no estate tax is payable, and the alternate valuation date election requires a tax reduction to qualify.
For qualified real property used in farming or a closely held business, the executor may elect to value the property based on its use value (farm or business value) rather than its highest-and-best-use fair market value. IRC § 2032A. The beneficiary’s basis reflects the reduced § 2032A value, not the market value. This reduces both the estate tax and the income tax basis — a trade-off that requires careful analysis.
The most important California-specific basis rule: for community property assets includible in a decedent’s gross estate, both the decedent’s one-half interest and the surviving spouse’s one-half interest receive a stepped-up basis at the first death. IRC § 1014(b)(6).
This is a dramatic departure from the treatment of jointly held separate property, where only the decedent’s share (typically one-half in joint tenancy) is stepped up. For a California couple holding low-basis community property, the community property character provides a full step-up on the entire asset at the first death, eliminating all embedded gain regardless of which spouse originally acquired the asset.
Example — community property vs. joint tenancy.
| Community Property | Joint Tenancy (Separate) | |
|---|---|---|
| Original purchase price | $200,000 | $200,000 |
| Value at first spouse’s death | $1,000,000 | $1,000,000 |
| Decedent’s share stepped up | $500,000 → $500,000 | $100,000 → $500,000 |
| Survivor’s share stepped up? | Yes → $100,000 becomes $500,000 | No — remains $100,000 |
| Survivor’s total basis after | $1,000,000 | $600,000 |
| Gain on immediate sale by survivor | $0 | $400,000 |
⚠️ CRITICAL PLANNING IMPLICATION — TRANSMUTATION. Spouses who hold community property may be tempted to transmute to joint tenancy for simplicity of title or survivorship mechanics. Transmutation from community property to joint tenancy eliminates the § 1014(b)(6) double step-up on the survivor’s half. For highly appreciated California assets, this is a costly mistake. Before recommending or consenting to a transmutation, model the capital gains tax impact on the survivor’s basis. A funded revocable trust with a community property designation is the standard mechanism for preserving both the step-up and the probate avoidance benefit.
The § 1014(b)(6) double step-up applies to community property includible in the decedent’s gross estate. For assets held in a revocable living trust with community property character properly maintained, the trust assets are includible in the decedent’s gross estate under IRC § 2038, and the § 1014(b)(6) step-up applies.
A stepped-up basis is denied for appreciated property that: (1) was acquired by the decedent by gift within one year before the decedent’s death; and (2) passes from the decedent back to the original donor (or the donor’s spouse). IRC § 1014(e). In that case, the property takes the donor’s original carryover basis — as if the gift had never been made for basis purposes.
This rule targets a specific abusive pattern: a donor transfers appreciated property to a terminally ill person (often a spouse or parent), the terminally ill person dies, and the appreciated property passes back to the donor with a stepped-up basis, eliminating the embedded gain without any estate tax cost. Section 1014(e) forecloses this.
Three conditions must all be present for § 1014(e) to apply:
If the property passes from the decedent to someone other than the original donor or donor’s spouse, § 1014(e) does not apply and the normal step-up rules govern.
⚠️ CRITICAL ISSUE — § 1014(e) IN TERMINAL ILLNESS PLANNING. This rule is encountered in practice more often than practitioners expect — particularly when a client is diagnosed with a terminal illness and family members consider transferring appreciated assets to the ill person to obtain a step-up. The one-year window and the pass-back requirement must be carefully analyzed before any such transfer. If the appreciated property passes at the decedent’s death to children or other third parties (not back to the original donor), § 1014(e) does not block the step-up. The anti-abuse rule is precisely targeted at the donor-gets-it-back scenario.
The § 1014 step-up does not apply to income in respect of a decedent (IRD) — items of income that the decedent had a right to receive but had not received (and therefore had not recognized for income tax purposes) at death. IRC § 691(a). The most significant categories of IRD are:
This is one of the most commonly misunderstood aspects of the step-up rule. A client who believes that “everything in my estate gets a step-up” will leave beneficiaries with a significant income tax surprise if the estate includes substantial retirement account balances.
⚠️ CRITICAL PLANNING IMPLICATION — RETIREMENT ACCOUNTS AND IRD. Because retirement accounts receive no step-up at death, they are generally the worst assets to pass through an estate from an income tax standpoint. Conversely, low-basis non-retirement assets — securities, real estate, closely held business interests — are the best assets to hold until death, because the § 1014 step-up eliminates their embedded gain. An effective basis planning strategy for most clients therefore reverses the intuitive order: spend retirement assets first (or convert to Roth) during life, and hold low-basis appreciated assets for the step-up at death rather than gifting them.
IRD beneficiaries are entitled to a deduction under § 691(c) for the portion of federal estate tax attributable to the IRD items. This deduction partially offsets the income tax on IRD, but it only applies in estates that actually owe federal estate tax — which, under the current $15 million exemption, excludes most clients.
| Feature | Gift (Appreciated) | Gift (Loss Asset) | Inheritance |
|---|---|---|---|
| Governing provision | IRC § 1015(a) | IRC § 1015(a) (dual basis) | IRC § 1014(a) |
| Donee/heir’s basis | Donor’s adjusted basis | FMV at gift (for loss); donor’s basis (for gain) | FMV at date of death |
| Embedded gain | Transferred to donee | N/A | Permanently eliminated |
| Embedded loss | Transferred to donee | Cannot be transferred — capped at FMV | Eliminated (step-down) |
| Holding period tacks? | Yes (for gains) | No (for losses) | No — fresh start |
| Gift tax adjustment available? | Yes — § 1015(d) (formula-limited) | N/A | N/A |
| Community property double step-up? | No | No | Yes — § 1014(b)(6) |
| IRD exception? | N/A | N/A | Yes — no step-up for IRD assets |
| One-year anti-abuse rule? | N/A | N/A | Yes — § 1014(e) if donor gets it back |
Every client who holds a low-basis appreciated asset faces a choice: gift it during life (removing future appreciation from the taxable estate but transferring the embedded gain) or hold it until death (obtaining a step-up but retaining the asset in the estate). The optimal choice depends on the interplay between the expected estate tax cost at death and the income tax cost of the embedded gain.
Under the post-OBBBA $15 million permanent exemption, most California clients will not pay federal estate tax. For those clients, the estate tax cost of retaining a low-basis asset is zero. Gifting the asset to remove it from the estate produces no estate tax savings — because there was no estate tax exposure — while simultaneously transferring the embedded gain to the recipient, who must eventually pay capital gains tax on it. This is a net negative.
The calculus shifts for clients whose estates substantially exceed $15 million. For those clients, gifting appreciated assets removes future appreciation from the taxable estate at a capital gains tax cost that may be lower than the 40% estate tax rate. The comparison is roughly: 23.8% (maximum long-term capital gains + net investment income tax) versus 40% estate tax on the same appreciation. Gifting can still make sense for the very large estate — but the analysis must be done explicitly, not assumed.
| Asset Type | Recommended Treatment |
|---|---|
| Low-basis appreciated stock / real estate (non-retirement) | Hold for § 1014 step-up unless estate clearly above $15M |
| Loss assets (FMV < basis) | Sell before gifting — recognize loss on donor’s return, gift cash |
| Community property — appreciated | Maintain community property character; do not transmute to joint tenancy |
| Traditional IRA / 401(k) | No step-up available; consider Roth conversion during life; spend first |
| Appreciated assets to terminally ill person | Analyze § 1014(e) before any gift; confirm pass-back structure |
Because traditional retirement accounts are IRD and receive no step-up, Roth conversions during the account holder’s lifetime convert IRD assets (taxable at ordinary income rates to heirs) into Roth assets (tax-free to heirs). The cost is current income tax on the conversion; the benefit is the elimination of the IRD burden on beneficiaries. For clients whose estates are below the estate tax exemption, the Roth conversion analysis is purely an income tax comparison — the marginal rate today versus the beneficiary’s expected marginal rate on distributions.
Diagnosing the Basis Issue at Client Intake
The § 1015(d) Gift Tax Adjustment
Planning for the Large Estate (Above $15M)
This article is provided for educational purposes and reflects federal and California law as of March 2026. It does not constitute legal or tax advice. Basis planning involves complex interactions among income tax, estate tax, and gift tax rules; consult qualified legal and tax counsel before making large gifts or restructuring asset ownership.
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