Keep a “Life Estate” When You Deed the House to the Kids and the IRS Still Steps Up the Basis When You Die. Give It Outright and They Inherit Your 1985 Purchase Price

She bought the three-bedroom ranch in 1985 for $95,000. At 74, a widow worried about probate, she signed a quitclaim deed giving the house to her son and daughter and kept living there. The deed took ten minutes at the kitchen table, and no lawyer was involved.

She died last spring with the house appraised at $700,000. The kids listed it, sold it, and their accountant told them their cost basis was their mother’s 1985 purchase price. Each of them owes tax on a $302,500 gain.

One extra clause in that deed, reserving a life estate for herself, would have reset the basis to $700,000 and left almost nothing to tax.

Two Code Sections Decide Which Basis the Kids Get

A lifetime gift carries the giver’s basis with it. Under 26 U.S.C. § 1015(b), property acquired by gift keeps “the same” basis it had in the hands of the donor. The kids inherit the 1985 number plus any recorded improvements.

A retained life estate changes the result. Under 26 U.S.C. § 2036(a)(1), the gross estate includes property the decedent transferred while keeping “the possession or enjoyment of, or the right to the income from” it for life. Keep the right to live there, and the house is pulled back into her estate at death.

That inclusion is exactly what the family wants. 26 U.S.C. § 1014(b)(9) grants a stepped-up basis to property required to be included in the gross estate, even when the heirs got title years earlier. IRS Publication 523 puts it simply: an inherited home’s basis is its fair market value when the owner dies.

Estate inclusion costs nothing for most families. The federal basic exclusion amount is $15,000,000 under § 2010(c)(3), so a $700,000 house creates no federal tax owed by the estate.

Running the Numbers on the Outright Gift

With the outright deed, the math works like this:

• Sale price: $700,000
• Carryover basis (1985 price): $95,000
• Total gain: $605,000
• Gain per child: $302,500

At the 15% long-term capital gains rate in 26 U.S.C. § 1(h)(1)(C), each child owes $45,375 in federal tax, for a family total of $90,750. That figure assumes the 15% bracket and leaves out state income tax and selling costs. Higher earners land in the 20% bracket and pay more.

Neither child can use the home-sale exclusion, because neither lived there. Home prices make the gap wider every year: the Case-Shiller national index rose from 184.204 in November 2016 to 336.741 in August 2026.

Same Deed Plus One Clause Wipes Out the Gain

Had the deed read “reserving to grantor a life estate,” she still could have stayed in the house until death and the kids still would have avoided probate. The basis then resets to the $700,000 appraisal. A sale at that price produces zero gain and zero federal tax, which keeps the $90,750 in the family.

The life estate carries trade-offs. She can’t sell or refinance without both children signing, and a child’s creditors or divorcing spouse can reach the remainder interest. A revocable trust, or a transfer-on-death deed in states that allow one, also gets the step-up while she keeps full control.

Five Moves That Protect the Step-Up

1. Pull the recorded deed from the county recorder and check whether it reserves a life estate. Many do-it-yourself quitclaims leave the clause out.
2. File Form 709 for any deed that gives away a remainder interest worth more than the $19,000 annual exclusion for 2026. The return uses up lifetime exemption. Gift tax is not owed until gifts exceed the exclusion amount.
3. Fix an outright deed early. If the kids deed the house back, § 1014(e) denies the step-up when appreciated property returns to the donor within one year of the owner’s passing. A fix made at 74 holds up far better than one made in the final months.
4. Order a date-of-death appraisal. When no estate tax return is filed, Publication 523 says the basis is the appraised value at death used for state inheritance or transmission tax purposes. Get that appraisal in writing before listing.
5. Keep the 1985 closing statement and improvement receipts. If the gift stands, every documented roof and kitchen raises the carryover basis.

Also consider whether the grantor retained an implied right to occupy or enjoy the property after the transfer. Even without an express life-estate provision, an implied agreement to retain possession or enjoyment may trigger estate inclusion under section 2036(a), depending on the facts. This can affect whether the property qualifies for a basis adjustment at death.

An estate  tax attorney can confirm which deed form your state recognizes and how a life estate interacts with your other plans.

One Number Sums It Up

One clause in the deed decides whether the kids sell at a basis of $95,000 or $700,000. On this house, that clause is worth $90,750 in federal tax.

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