The tax implications of a Transfer on Death designation fall into four buckets: the federal estate tax, possible state estate or inheritance tax, capital gains tax when the beneficiary later sells, and ordinary income tax on anything the asset earns after the transfer. A TOD designation skips probate, but it does not remove the asset from the tax system. What it does do, for most assets, is hand the beneficiary a stepped-up basis that can wipe out decades of built-in capital gains.
The Stepped-Up Basis Is the Main Tax Advantage
When you sell an asset, capital gains tax applies to the difference between the sale price and your basis, which is roughly what the original owner paid plus improvements. A TOD beneficiary does not inherit that original basis. The basis resets to the asset’s fair market value on the date the owner died.1Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
The effect is dramatic on appreciated property. Say a parent bought stock decades ago for $100,000, and it’s worth $500,000 when they die. Through a TOD designation, the beneficiary inherits it with a new basis of $500,000. Selling it the next week for $500,000 produces zero taxable gain. The $400,000 of lifetime appreciation is erased for tax purposes.
Compare that with receiving the same stock as a lifetime gift. A gift carries over the donor’s original basis of $100,000.2Office of the Law Revision Counsel. 26 USC 1015 – Basis of Property Acquired by Gifts and Transfers in Trust A later sale at $500,000 produces a $400,000 taxable gain, potentially subject to federal capital gains rates and the 3.8% Net Investment Income Tax.3Internal Revenue Service. Net Investment Income Tax For appreciated assets, the TOD route is far more tax-efficient than a lifetime gift.
The Step-Down Works Against You
The basis adjustment runs both directions. If an asset is worth less at death than what the original owner paid, the basis steps down to the lower date-of-death value, and the built-in loss disappears. Nobody deducts it. A parent who paid $200,000 for stock now worth $120,000 at death passes a $120,000 basis to the beneficiary, and the $80,000 loss is gone. This is why advisors sometimes suggest selling depreciated assets before death to harvest the loss instead of routing it through a TOD.
Community Property States Get a Double Step-Up
Married couples in community property states get an extra benefit. When one spouse dies, both halves of community property receive the stepped-up basis, not just the deceased spouse’s half.1Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent Outside community property states, only the deceased spouse’s half of jointly held property is adjusted, and the surviving spouse’s half keeps its original basis. If the surviving spouse later sells, the difference in tax bills can be substantial.
Federal Estate Tax Still Applies
Skipping probate is not the same as skipping estate tax. TOD assets are part of the decedent’s gross estate under federal law because the decedent owned or controlled them at death.4Office of the Law Revision Counsel. 26 USC 2033 – Property in Which the Decedent Had an Interest That inclusion is actually what qualifies the asset for the stepped-up basis, so the trade generally works in the family’s favor.
For 2026, the federal estate tax exemption is $15,000,000 per individual, set by legislation signed into law on July 4, 2025.5Internal Revenue Service. Estate and Gift Tax Updates Married couples can effectively shield up to $30,000,000 combined through portability, which lets a surviving spouse claim the deceased spouse’s unused exemption. Only the value above the exemption is taxed, and the top rate is 40%.6Office of the Law Revision Counsel. 26 USC 2001 – Imposition and Rate of Tax
Most estates owe nothing. But an estate must file Form 706 if the gross estate exceeds the exemption, and married couples should consider filing even below that threshold, because Form 706 is the only way to elect portability and preserve the deceased spouse’s unused exemption.7Internal Revenue Service. Frequently Asked Questions on Estate Taxes Skipping that filing is a common and expensive mistake.
State Estate and Inheritance Taxes
A minority of states impose their own death taxes, and the thresholds are often far lower than the federal exemption. Some states levy an estate tax paid by the estate before distribution. Others levy an inheritance tax paid by each beneficiary. One state imposes both.
Inheritance tax rates usually depend on the beneficiary’s relationship to the decedent. Spouses and direct descendants are frequently exempt or taxed lightly. More distant relatives and unrelated beneficiaries face the steepest rates, which can reach 16% in some states. A TOD asset going to a child might trigger no state inheritance tax at all, while the same asset going to a close friend could produce a real bill.
Which state’s rules apply depends on where the decedent lived. For real estate, the property’s location controls, so a TOD deed on a home in a state that imposes death taxes can pull an out-of-state beneficiary into that state’s system.
Income Tax for the Beneficiary
Receiving a TOD asset is not itself a taxable income event. Federal law excludes the value of inherited property from gross income.8Office of the Law Revision Counsel. 26 USC 102 – Gifts and Inheritances You don’t report the value of the inherited asset on the return for the year you received it.
What you do owe tax on is anything the asset produces after the transfer. Dividends, interest, and rent generated after the date of death are ordinary income taxed at your regular rate. If you sell the asset later, any gain above the stepped-up basis is a capital gain, short-term or long-term depending on how long you held it after the date of death.
Retirement Accounts Are the Big Exception
Everything above applies to standard assets like brokerage accounts, real estate, and bank accounts. Retirement accounts work differently, and the treatment is much less favorable.
Traditional IRAs and 401(k)s passed to a beneficiary do not receive a stepped-up basis. The entire balance is income in respect of a decedent, and every dollar the beneficiary withdraws is taxed as ordinary income. There’s no basis reset to soften the blow.
Most non-spouse beneficiaries must also empty an inherited retirement account within 10 years of the original owner’s death under the SECURE Act.9Internal Revenue Service. Retirement Topics – Beneficiary That compressed schedule can push a large balance through a beneficiary’s tax returns over a few years and lift them into higher brackets. Exceptions to the 10-year rule apply to surviving spouses, minor children (until they reach the age of majority), disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the decedent.
Surviving spouses have the most flexibility of any beneficiary class. A spouse can roll the inherited account into their own IRA and treat it as their own, delaying distributions until their own required beginning date.
Documenting Fair Market Value at Death
The stepped-up basis only helps if you can prove what the asset was worth on the date of death. Publicly traded stocks and funds are easy because market prices are recorded daily. Real estate, closely held business interests, and other hard-to-value assets need a professional appraisal as of the date of death.
When an estate files Form 706, the executor also files Form 8971 and gives each beneficiary a Schedule A reporting the value of inherited property. Beneficiaries must then use a basis consistent with the estate tax value reported on that schedule.10Internal Revenue Service. Instructions for Form 8971 and Schedule A Claiming a higher basis than the reported value can draw accuracy-related penalties.11Internal Revenue Service. Gifts and Inheritances
Estates that don’t need to file Form 706 have no formal consistency requirement, but you should still keep records. Save the brokerage statement showing the date-of-death price. Get an appraisal on real estate and hang onto it. The IRS can challenge a claimed basis years after the fact, and the burden of proof sits with you.
The Alternate Valuation Date
If estate assets fall significantly in the six months after death, an executor can elect to value the estate at the six-month mark instead of the date of death.12Office of the Law Revision Counsel. 26 USC 2032 – Alternate Valuation The election must reduce both the gross estate value and the total estate tax, is only available when Form 706 is filed, and cannot be undone once made. Beneficiaries end up with a lower stepped-up basis in exchange for a smaller estate tax bill, so it only pays off for taxable estates where the estate tax savings beat the future capital gains cost.
One Boundary Worth Knowing
A TOD designation does not reliably shield the asset from the decedent’s creditors. Many states let creditors reach non-probate assets when the probate estate can’t cover outstanding debts, which means a TOD beneficiary can be asked to contribute toward satisfying those debts. This isn’t a tax issue by itself, but it can shrink what the beneficiary keeps. If the decedent had significant debt, get legal advice before spending the inheritance.