Income in Respect of a Decedent: The Assets That Never Get a Step-Up

The practical point is narrow and expensive: "hold it until death and the basis steps up" is true for a building and false for an IRA, an unpaid bonus, or an installment note.

What counts as IRD

• Traditional IRAs, 401(k)s and other pre-tax retirement accounts. The largest category by far.
• Installment obligations — the unreported gain on a note from a §453 sale.
• Unpaid wages, commissions, bonuses and deferred compensation earned before death.
• Accounts receivable of a cash-basis business, including a professional practice.
• Accrued but unpaid partnership distributive shares. An S corporation works differently — its income lands on the decedent's final return and the stock gets a §1014 step-up, so IRD arises only indirectly under §1367(b)(4)(B), where the corporation itself holds IRD items such as cash-basis receivables.
• Accrued interest on savings bonds where the decedent deferred reporting it.
• Declared but unpaid dividends where the record date preceded death.

Roth IRAs are the notable exception among retirement accounts: qualified distributions are income-tax-free, so there is no embedded income to inherit. Life insurance death benefits are not IRD either — §101(a) excludes them from income entirely.

Why there is no step-up

§1014(a) gives most inherited property a basis equal to its fair market value at death, which is why a building bought for $400,000 and worth $3,000,000 passes to heirs with a $3,000,000 basis and the lifetime gain simply disappears. §1014(c) carves IRD out of that rule. The logic is consistent, even if the result stings: the decedent never paid income tax on that money, so allowing a step-up would let it escape income tax permanently.

The result is that the same dollar can be reached twice — once by the federal estate tax in the estate, and again by income tax when the heir collects it.

§691(c) — the deduction nobody claims

When IRD is included in a taxable estate, §691(c) lets the recipient deduct the federal estate tax attributable to that IRD as they report the income. Points that matter in practice:

• It is an itemized deduction, but §67(b)(7) exempts it from the 2%-of-AGI floor, so it survives the current suspension of miscellaneous itemized deductions.
• It is claimed proportionally, as the income is recognized — not all at once. An heir drawing an inherited IRA over ten years deducts a slice each year.
• Only federal estate tax counts, and only the incremental tax caused by including the IRD. If the estate owed no federal estate tax, there is no §691(c) deduction.
• The information needed to compute it lives in the estate tax return. If nobody hands the heir Form 706, the deduction is simply lost.

Installment notes and death

A seller who structures a sale under §453 and dies mid-term leaves an asset with unreported gain. Three rules govern what happens:

1. Death alone does not accelerate the gain. §453B(c) provides that transmission at death is not a disposition. The estate or beneficiary steps in and continues reporting on the same Form 6252 with the same gross profit percentage.
2. The remaining gain is IRD. §691(a)(4) says so explicitly, and §691(a)(3) keeps its original character — capital gain stays capital gain, unrecaptured §1250 gain stays §1250 gain. No step-up.
3. Forgiving the note in your will backfires. Under §691(a)(5)(A)(iii), if the obligation is cancelled at death or becomes unenforceable, or is transferred to the obligor, it is treated as a disposition and the deferred gain is triggered — reported by the estate. If the obligor is a related party, fair market value is deemed to be no less than the face amount, so discounting it does not help. A parent who sells to a child on a note and then kindly forgives the balance has generated a tax bill for the estate.

This is the honest weakness of an installment sale as an estate plan. It defers tax for the seller's lifetime, but it does not erase it the way holding the building itself would have.

The comparison people actually need

Neither column is the right answer on its own. Holding until death is unbeatable on tax and useless if you need the money or want out of the asset. An installment sale solves the cash and the exit and leaves an IRD asset behind.

What planning actually does about it

The IRD problem is not solved by structuring the sale differently, because the deferred gain has to sit somewhere. It is normally addressed on the other side of the balance sheet:

• Leave the IRD asset to charity. A charity pays no income tax on it, so the IRD discount disappears. Give heirs the stepped-up assets and give the IRA or the note to a charitable beneficiary if charity is already part of the plan.
• Make sure the §691(c) deduction is actually computed. It requires the estate tax return, and it is routinely missed by a preparer who never sees it.
• Replace the tax with an asset that is not taxed. Life insurance proceeds are income-tax-free under §101(a), and a policy owned by an irrevocable trust is generally outside the taxable estate as well. For a seller deliberately leaving heirs an IRD asset, a policy sized to the projected income tax is the standard offset — funded from the installment payments themselves, which is why the two decisions belong in the same conversation.
• Spend the IRD first. If retirement spending can come from the IRA and the note while the appreciated property is held for the step-up, the IRD pile shrinks before it is ever inherited.

None of these are exotic. They fail because the IRD question comes up after the sale, when the only remaining variable is who gets what.

Frequently asked

Q: What is income in respect of a decedent in simple terms? A: It is money the deceased person earned or was entitled to but had not yet paid income tax on — an IRA, an unpaid bonus, business receivables, or the unreported gain on an installment note. Whoever inherits it pays the income tax the decedent would have paid.

Q: Does an inherited IRA get a step-up in basis? A: No. A traditional IRA is income in respect of a decedent, and §1014(c) denies the step-up. Distributions are taxed as ordinary income to the beneficiary, generally over ten years under the SECURE Act rules. A Roth IRA has no embedded income tax, so the question does not arise.

Q: Is IRD taxed twice? A: It can be included in the taxable estate and then taxed again as income to the recipient. §691(c) partially relieves this by letting the recipient deduct the federal estate tax attributable to the IRD as the income is reported, but only if federal estate tax was actually paid.

Q: What is the §691(c) deduction? A: An income-tax deduction for the portion of federal estate tax caused by including IRD in the estate. It is an itemized deduction exempt from the 2% floor under §67(b)(7), and it is claimed proportionally as the income is recognized rather than all at once.

Q: What happens to an installment sale if the seller dies? A: The gain is not accelerated. §453B(c) treats transmission at death as something other than a disposition, so the estate or beneficiary continues reporting on Form 6252 using the original gross profit percentage. The remaining gain is IRD under §691(a)(4) and receives no step-up.

Q: Can I forgive an installment note in my will? A: You can, but it triggers the tax. §691(a)(5)(A)(iii) treats cancellation at death, or transfer of the obligation to the person who owes it, as a disposition, so the deferred gain is recognized. If the obligor is a related party, the note is valued at no less than face.

Q: Is life insurance income in respect of a decedent? A: No. Death benefits are excluded from gross income under §101(a). The proceeds may still be included in the taxable estate if the decedent owned the policy or held incidents of ownership, which is why policies intended to offset an estate tax are typically owned by an irrevocable trust.

Q: How do heirs find out an asset is IRD? A: Usually from the estate's fiduciary or the Form 706. There is no notice on a Form 1099, and a preparer who did not handle the estate often has no way to know, which is how the §691(c) deduction gets lost. Ask the executor for the estate tax return before filing the first return that reports the income.

Related

• Structured installment sale — the §453 structure that creates the IRD asset, and what it buys you
• Form 6252 — the return the estate or beneficiary continues filing
• Charitable remainder trust vs. installment sale — the other way to handle an asset you are exiting
• Depreciation recapture — the part of the gain that keeps its character through death