Partial Step-Up Math: Exchanging Property You Inherited Half Of

How the property was titled decides how much of it steps up

Section 1014 sets the basis of property acquired from a decedent at its fair market value at death. The question for a co-owner is how much of the property counts as acquired from the decedent, and the answer depends on title and state law.

For spouses holding as joint tenants with right of survivorship or tenants by the entirety, section 2040(b) includes one-half of the value in the estate, and Publication 551 says it does not matter who paid. The survivor's basis is the cost of their own half, reduced by depreciation allowed to them, plus the stepped-up value of the inherited half.

For other joint tenants, such as a parent and child, section 2040(a) includes the whole value except the part shown to have come from the survivor's own money, and Publication 551 works an example with two-thirds included. Tenants in common are simpler: the decedent's share passes under the will or trust and steps up, and yours does not.

Community property steps up in full, which can leave nothing to exchange

Publication 551 lists the community property states as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. When either spouse dies, the total value of community property, including the survivor's half, generally becomes the basis of the whole property, as long as at least half the value of the community interest is includible in the decedent's estate. That rule comes from section 1014(b)(6).

A surviving spouse with community property may therefore have little or no gain. If the rental is sold soon after death for about its date-of-death value, there is nothing to defer and an exchange would add cost without benefit.

Title matters even in those states. A rental held as joint tenants rather than as community property may be treated under the joint tenancy rule, so have your attorney confirm how the property was characterized before your CPA sets the basis.

Worked model: a $1,200,000 rental where only half steps up

Hypothetical: a married couple in a common-law state bought a rental in 2006 for $500,000 and took $200,000 of depreciation, $100,000 attributable to each half. Their adjusted basis is $300,000, $150,000 per half. One spouse dies in 2026 when the property is worth $1,200,000.

The survivor's basis is $150,000 for their own half plus $600,000 for the inherited half, $750,000 in all. A sale at $1,200,000 net produces a $450,000 gain, of which $100,000 is the survivor's own depreciation in the 25% layer. On a joint return for the year of death, which Publication 559 allows, with $450,000 of other taxable income, the tax is $25,000 on that layer, $66,815 on the remaining $350,000 at 15% and 20%, and $17,100 of net investment income tax: $108,915.

Had both spouses been alive, the $900,000 gain would have cost $224,200. In a community property state with both halves stepped up, the gain would be about zero. The 2026 breakpoints come from Rev. Proc. 2025-32. Run your own numbers with your CPA.

• Common-law joint tenancy: basis $750,000, gain $450,000, federal tax about $108,915.
• Community property, full step-up: basis about $1,200,000, gain about zero.
• No death at all: basis $300,000, gain $900,000, federal tax $224,200.

An exchange defers the half that did not step up, and the inherited half's depreciation history disappears

If you exchange instead of selling, section 1031 defers the $450,000 and the replacement inherits the $750,000 basis. The $100,000 of depreciation on your own half stays in the deferred gain; the $100,000 taken on the decedent's half does not, because Publication 544 states that no ordinary income from depreciation is reported on a transfer at death.

Timing changes the brackets. A surviving spouse can file jointly for the year of death, and Publication 559 explains that a qualifying surviving spouse may use joint rates for the next two years; otherwise a later sale is taxed on single brackets, where the 20% rate starts at $545,500 of taxable income.

The inherited half also starts a new holding period that section 1223(9) treats as more than one year, so a quick sale is still long-term gain. If the estate files an estate tax return, Publication 544 requires your starting basis to be consistent with the value reported to the IRS.

Choosing between selling, exchanging and holding

Sell when the remaining gain is small, as it often is with community property, or when you need the cash. Exchange when a meaningful gain remains on your own half and you want to stay invested; inherited rental options and step-up versus exchanging now compare the paths. Siblings who inherit together face their own version, set out in splitting an inherited property among siblings.

Holding until your own death steps up your half too, so heirs receive the whole property at full value. Survivors who want to keep that option but stop managing often exchange into a Delaware statutory trust, which Rev. Rul. 2004-86 treats as real property for section 1031 and which can pass to heirs at a stepped-up basis.