What happens if the IRS says my stepped-up basis was too high?

Why basis matters when you sell an inherited house

When you inherit a house, your starting point for capital gains is usually not what Mom paid in 1979. Under Internal Revenue Code section 1014, the basis of inherited property is generally its fair market value at the date of death (or the alternate valuation date, if the executor elects it).

When you sell, your gain is roughly the sale price minus that basis and selling costs. A higher basis means less gain and less tax. You can see the temptation. Bump the date-of-death value up a little, and the tax bill shrinks a little.

The IRS can see the temptation too. If it decides the basis was too high, the gain goes up, the tax goes up, and the question becomes whether a penalty comes along for the ride.

This is general information. Tax treatment depends on the facts, so work with a CPA or tax attorney if you are facing an IRS question about basis.

The 20% and 40% penalties

Section 6662 adds a penalty equal to 20% of the portion of an underpayment it applies to. One of the triggers is a substantial valuation misstatement.

There is a floor. Under section 6662(e)(2), this valuation penalty does not apply unless the underpayment caused by the misstatement for the year is more than $5,000.

Here is a hypothetical. Say the correct date-of-death value was $600,000, and the return claimed a basis of $900,000. That is exactly 150% of the correct amount, so it hits the substantial misstatement line, assuming the extra tax tops $5,000. Claim $1,200,000, and you are at 200% and the 40% tier. At that point the house is not overvalued. It is wearing a costume.

The consistency rule: when the estate tax value is the ceiling

There is a second trap, and it applies when the estate filed an estate tax return.

Section 1014(f) says the heir's basis cannot exceed the value finally determined for estate tax purposes. That cap applies to property whose inclusion in the estate increased the estate tax. In plain terms: if the house was valued at one number on the estate tax return and it raised the estate tax, the heir cannot later claim a higher basis when selling.

Failing to follow that rule has its own penalty. Section 6662(b)(8) covers an "inconsistent estate basis," which section 6662(k) defines as an underpayment from not complying with section 1014(f).

To help heirs stay consistent, the Form 706 instructions say certain estates must report each asset's estate tax value to the IRS and to the people receiving it on Form 8971, within 30 days of the Form 706 due date, including extensions. If you received one of those statements, that number matters.

How a real appraisal protects you

Section 6664(c) says a penalty under section 6662 will not apply to a portion of an underpayment if the taxpayer shows reasonable cause and acted in good faith. Whether you qualify depends on the facts, and your tax professional is the person to make that case.

What I can tell you is what an appraiser brings to the table. Kiplinger notes that a formal appraisal can serve as objective documentation to protect heirs if the IRS audits the tax basis, and warns that an unverified or inflated basis can bring penalties and interest.

A Zestimate screenshot is not documentation. Neither is the listing price a year later, after the new kitchen. A credible date-of-death appraisal values the house as of that date, in its condition that day, using sales from that market. It shows the comps, explains the adjustments, and says why the value is what it is. If the IRS asks how you got your number, you hand them the report instead of a shrug.

What to do if the IRS questions your basis

1. Call your CPA or tax attorney first. Do not respond to an IRS notice on your own if a penalty is on the table.
2. Find the appraisal. Locate the date-of-death report, or the value used on the estate tax return and any Form 8971 statement.
3. Check the effective date. Make sure the value is as of the date of death, or the alternate valuation date if one was elected.
4. Gather condition evidence. Photos, inspection reports and records of the home as it was on that date.
5. If there was no appraisal, get a retrospective one. An appraiser can value the home as of the past date using sales from that time.
6. Consider a desktop review if the IRS or anyone else has produced its own value. A second opinion checked against the evidence can show where the numbers differ and why.

What I see in the field

Estate and probate work is a big part of my practice. The basis problems I see usually do not start with someone trying to cheat. They start with a guess: an online estimate, a neighbor's sale, or a value pulled from memory years later.

Guesses tend to drift upward, because everyone likes a lower tax bill. Evidence does not drift. A report that teaches the market at the date of death, with real sales and clear reasoning, gives you a basis you can explain to anyone. Facts over feelings is a nice slogan. In an audit it is a strategy.