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Avoiding Capital Gains Tax On Inherited Property

Inheriting property can feel like a gift, but it may come with tax concerns, especially when selling it. This guide will help break down all the questions you may have. Do I have to pay taxes on inheritance? What is capital gains on inherited property? How to avoid paying capital gains tax on inherited property?

Table of contents

Key Takeaways:...Read more

Do you have to pay taxes on inheritance?...Read more

Capital gains tax on inheritance...Read more

How to avoid paying capital gains tax on inherited property...Read more

How is inherited property taxed when sold?...Read more

Key Takeaways:

Capital gains tax on inherited property is based on the difference between its value at inheritance and the sale price.
Selling inherited property quickly can help you avoid capital gains tax if there’s no increase in value.
You can also turn the property into your primary home to reduce your taxable gains.

Do you have to pay taxes on inheritance?

When you inherit property or assets, you might ask, do you have to pay taxes on inheritance? There is no federal inheritance tax, so you won’t owe taxes just for receiving an inheritance. However, some states do have inheritance taxes, which are separate from federal taxes, and they only apply in a few places like Iowa, Kentucky and Pennsylvania. Even then, most close relatives like spouses, children, or parents are often exempt. One key tax consequence after inheritance happens when you sell inherited property. This is where capital gains tax comes in, based on how much the property's value has increased since the original owner bought it.

Infographic entitled Inheritance Tax States to answer the question do i have to pay taxes on inheritance.

Capital gains tax on inheritance

Capital gains tax is a tax on the profit made when you sell something valuable, like a car, real estate, stocks or bonds. It’s based on the difference between what you originally paid for the item and the price you sell it for. The amount of capital gains tax you owe depends on factors like how long you owned the asset, your income level and where you live. There are two types of federal capital gains tax: short-term and long-term. If you sell an asset within one year of owning it, the short-term capital gains tax applies, which is the same as your regular income tax rate. If you hold the asset for more than a year before selling, the long-term capital gains tax applies. The rate for long-term capital gains is 0%, 15%, or 20%, depending on your income, and is usually lower than the short-term rate. When you inherit property, capital gains tax comes into play if you sell it for more than what the original owner paid. You can also claim a deduction if you sell it for less than its inherited value. The key difference with inherited property is that the IRS uses something called a "stepped-up basis." This means you base the capital gains tax on the value of the property at the time you inherited it, not what the original owner paid. This can reduce the amount of tax you owe when selling the property. Let’s say your grandparents bought a vacation home in the 1970s for $50,000. By the time you inherit it, the property’s value has increased to $600,000. Normally, you’d owe capital gains tax on the $550,000 difference between what your grandparents paid and its current value. This could lead to a huge tax consequence after inheritance, but the IRS allows you to use a stepped-up basis instead. If you later sell the property for $650,000, and the stepped-up basis at the time of inheritance was $600,000, you’d only owe capital gains tax on the $50,000 increase. This step-up helps minimize the tax you’ll owe when selling inherited property

How to avoid paying capital gains tax on inherited property

There are many ways to reduce the tax consequences after inheritance.

Infographic entitled Avoid Capital Gains Tax On Inherited Property listing five ways to do it.

Sell the property quickly : One of the easiest ways to avoid tax is to sell the inherited property immediately. If you sell the property for the same amount it was worth when you inherited it, there’s no profit and therefore no gains tax. Even if you sell it for less, you won’t owe any capital gains tax on inheritance.
Deduct selling expenses : If you do make a profit from selling, you can reduce the capital gains by deducting expenses like repairs or closing costs. For example, if you have $75,000 in capital gains but spend $30,000 on selling costs, you’d only owe tax on the remaining $45,000.
Make it your primary residence : If you move into the property and make it your main home, you can qualify for the Section 121 exclusion. This allows you to exclude up to $250,000 (or $500,000 for couples) in capital gains when you sell, as long as you live there for at least two of the five years before selling. However, you can’t use this exclusion if you've sold another primary home in the past two years.
Rent it out : If you’re not ready to sell or move in, consider renting out the property. Later, if you sell the property, you can defer paying taxes by doing a 1031 exchange, which lets you reinvest the proceeds into another rental property. Without reinvesting, you’ll owe taxes when you sell.
Disclaim the inheritance : If you prefer to avoid the property and its potential tax consequences altogether, you can disclaim the inheritance. By signing a legal disclaimer, you give up your rights to the property and it passes to the next heir. Keep in mind that this decision is final and cannot be reversed.

How is inherited property taxed when sold?

When you sell inherited property, the tax depends on the difference between its stepped-up basis and the sale price. The stepped-up basis is the property’s fair market value at the time of inheritance, not what the original owner paid. So, you’re only taxed on any gain made after you inherited it. For example, if the property was worth $450,000 when you inherited it and you sell it for $500,000, you’d be taxed capital gains on inherited property on the $50,000 difference. Long-term capital gains tax rates apply, even if you haven’t owned the property for long. You can also reduce your taxable gains by deducting expenses tied to the sale, such as agent fees, repairs, and closing costs. If you spent $15,000 on these expenses, your taxable gain would drop to $35,000. A tax professional is a good resource that can help you manage capital gains tax or even help you avoid it.

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