Among the tax advantages associated with real estate investing, the step-up in basis is one of the most significant for investors thinking about legacy and long-term wealth transfer. It doesn’t affect your returns during your lifetime — but it can have an enormous impact on what your heirs ultimately receive. Here’s how it works.
What Is Cost Basis — and Why Does It Change Over Time?
Your cost basis in an investment is generally what you paid for it. When you sell, your taxable gain is the difference between what you receive and your cost basis.
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In real estate, cost basis doesn’t stay static. Each year that depreciation is taken, the basis is reduced. A property purchased for $500,000 with $100,000 of depreciation taken against it has an adjusted basis of $400,000 — so the taxable gain at sale is measured from $400,000, not $500,000. For investors who have executed a series of 1031 exchanges over many years, this effect compounds: accumulated depreciation and deferred gains carry forward from property to property, and the gap between adjusted basis and current market value can grow very large over time.
What Is the Step-Up in Basis?
Under current U.S. tax law, when an asset is inherited, the cost basis is reset — “stepped up” — to the fair market value at the time of the original owner’s death. The accumulated gains from the owner’s lifetime are effectively erased for the heir.
Consider a property purchased for $500,000, with basis reduced to $300,000 through depreciation, now worth $1,000,000. The taxable gain that had been building — $700,000, not just the $500,000 in appreciation — is erased entirely. An heir receives a new basis of $1,000,000 and owes little or no capital gains tax if they sell at that value. For an investor who has executed multiple 1031 exchanges over decades, the step-up can erase a lifetime of compounding deferred gains and depreciation recapture in a single event — making it one of the most significant wealth transfer tools available under current tax law.
How This Applies to LP Interests and Long-Term Planning
LP interests in real estate partnerships are subject to the same step-up rules as other assets. The investor benefits from income, appreciation, and tax advantages during their lifetime — and at death, the accumulated gains reset for heirs, who can continue receiving income or exit with minimal tax consequences.
This changes the calculus of when to sell. Rather than selling an appreciated asset and paying a significant capital gains tax, patient investors may find it makes more sense to hold, enjoy the ongoing income, and allow the asset to transfer to heirs with a clean basis. The right approach depends on individual goals, liquidity needs, and estate plan — which is why coordinating your CPA, estate attorney, and financial advisor matters so much.
An Important Note
The step-up in basis has been a feature of U.S. tax law for many decades, but like all tax law, it is subject to legislative change. Estate planning strategies built around current rules should be reviewed periodically and stress-tested against the possibility that rules may evolve. Your estate attorney and CPA are the right people to help you stay current.
Key Takeaways
- Cost basis starts at purchase price but is reduced over time by depreciation — increasing the eventual taxable gain
- 1031 exchanges carry accumulated depreciation and deferred gains forward, which can compound the deferred liability significantly over time
- At death, the step-up in basis resets the cost basis to current fair market value — erasing both appreciation and accumulated depreciation
- LP interests are subject to the same step-up rules, making passive real estate a powerful tool for generational wealth transfer
- Tax law can change — coordinate with your estate attorney and CPA to ensure your plan is current and stress-tested
Win Coleman, CCIM, is a graduate of East Carolina University where he received his bachelor’s degree in finance. He holds both North Carolina and South Carolina Real Estate Licenses and was awarded the prestigious CCIM (Certified Commercial Investment Member) designation in 2008.
Win served on the board of directors of The Triangle Apartment Association (TAA) where he co-chaired The Independent Rental Owner’s Council (IROC). He is a member of the International Council of Shopping Centers (ICSC), the Triangle Commercial Association of Realtors (TCAR) and the Raleigh Kiwanis Club.
While a specialist in site identification, evaluation and acquisition for investors and businesses, he also has extensive experience in brokerage, leasing, property management and investment sales.
Win assists in managing The Coleman Group, LLC, which owns a portfolio of investment properties, and he is a member of our acquisitions committee. He has lifelong experience and love for historic properties including the one he restored and where he resides in Historic Oakwood in Downtown Raleigh.