Stepped-Up Basis on Inherited Property — How Does This Work With Estate Tax?

My dad passed away last month and I inherited a duplex in Austin. He bought it in 1995 for $120K, it's now worth about $850K. My CPA says I get a "stepped-up basis" to the current value so if I sell now I'd owe basically zero capital gains.

But here's my confusion: Dad's total estate is about $3.5M. No estate tax at the federal level (under exemption). Texas has no state estate tax. So am I basically getting this $730K in appreciation completely tax-free? That seems too good to be true.

Also — I'm considering keeping it as a rental. If I hold it for 5 years and it appreciates to $1.1M, do I only pay capital gains on the $250K gain above the stepped-up $850K basis?

Your CPA is correct. The stepped-up basis is one of the most powerful tax benefits in the code. Here's how it works:

• Your basis = fair market value at date of death ($850K)
• If you sell immediately: $850K - $850K = $0 gain, $0 tax
• If you hold and sell at $1.1M: $1.1M - $850K = $250K gain, taxed at long-term capital gains rates (15-20%)

And yes, the $730K in appreciation during your father's lifetime is permanently erased for income tax purposes. It's not "too good to be true" — it's the law (IRC Section 1014).

Texas having no state estate tax means your father's estate pays zero at both state and federal levels. The Texas estate tax guide confirms this — Texas constitutionally prohibits a state estate tax.

One important nuance: get a proper appraisal at or near the date of death. The IRS can challenge your stepped-up basis value if you don't have documentation. A $500 appraisal now protects a $730K tax benefit — best ROI you'll ever get.

Also, if you convert it to a rental, you can depreciate the building portion based on the stepped-up value. On an $850K property (say $650K building, $200K land), that's about $23,600/year in depreciation deductions. The step-up effectively gives you a fresh depreciation schedule.

I went through this last year with 3 rental properties in Colorado. Total inherited value ~$1.8M, Dad's original basis ~$400K. Stepped-up basis saved us about $280K in capital gains tax.

One thing I wish I'd known: if the decedent was married, in a community property state, BOTH halves of community property get stepped up. In common law states (like Colorado), only the decedent's half gets the step-up. My parents were in a common law state so we only got 50% of the benefit we could have gotten.

For OP in Texas: Texas is a community property state, so if your dad was married and the duplex was community property, your mom's half also gets stepped up. That's the full double step-up.

My parents were divorced, so community property doesn't apply here. But good to know for others reading.

Follow-up question: if I do a 1031 exchange from the inherited duplex into a larger property, does the stepped-up basis carry over to the new property?

Yes, in a 1031 exchange the basis carries forward. So your $850K stepped-up basis would transfer to the replacement property. If you exchange into a $1.2M property (adding $350K cash), your basis in the new property would be $1.2M ($850K carried + $350K new money).

The key advantage: you deferred the gain on any post-inheritance appreciation AND you get to depreciate the new property's building value. It's a powerful combination when starting from a stepped-up basis.

Worth noting for anyone in Arizona: we're also a community property state, so you get the double step-up. Plus Arizona recently adopted a community property trust option for people who moved from common law states. You can convert separate property to community property specifically to get the double step-up. The Arizona estate planning guide covers this.

Quick question piggybacking on this thread: does the stepped-up basis apply to stocks and investment accounts too, or just real estate?

Yes, it applies to virtually all inherited assets — stocks, bonds, real estate, business interests, art, collectibles. The basis resets to FMV at date of death for everything. The only major exception is retirement accounts (IRAs, 401ks) — those are "income in respect of a decedent" (IRD) and the beneficiary pays income tax on distributions at ordinary rates. No step-up for IRAs.

This is why estate planning often involves holding appreciated stocks until death rather than selling them. The gains die with the owner. It's sometimes called the "angel of death" loophole.

Update: Got the appraisal done ($750 for a commercial duplex appraisal). FMV at date of death: $862K. CPA confirmed the stepped-up basis. I've decided to hold the property as a rental — the new depreciation schedule alone will save about $8K/year in taxes. Thanks for all the guidance.