Do You Pay Capital Gains Taxes on Property You Inherit?

Takeaways

• Inherited property generally receives a stepped-up tax basis to its fair market value on the original owner’s date of death, which can reduce or eliminate capital gains taxes if you sell soon afterward.

• If the property appreciates after you inherit it, you generally pay capital gains tax only on the increase in value after the date of inheritance.

• The personal residence exclusion may allow you to exclude up to $250,000 of capital gains, or $500,000 for a married couple, if you meet the ownership and use requirements.

• Gifting property during the original owner’s lifetime generally does not provide the same stepped-up basis as inheriting property.

• An appraisal is usually the best way to establish the property’s fair market value and tax basis when you inherit it.

• Because tax rules and individual circumstances vary, consult an estate planning or tax professional before selling, gifting, or disclaiming inherited property.

If you inherit a house, stocks, or other property, you generally do not owe federal income tax simply because you received it. Taxes may come into play later if you sell the property for more than its adjusted tax basis.

Fortunately, inherited property generally receives a “step-up” in basis. This means the tax value is usually adjusted to the property’s fair market value when the original owner dies. As a result, you may owe little or no capital gains tax if you sell the property soon after inheriting it.

What Is Capital Gain?

Capital gain is the difference between the “basis” in property — usually real estate or stocks, but also including artwork and collectibles — and its selling price. The basis is usually the purchase price of property.

If you purchased a house for $250,000 and sold it for $450,000, you would have $200,000 of “gain” ($450,000 − $250,000).

However, the basis can be adjusted if you spend money on capital improvements. For instance, if after buying your house you spent $50,000 updating the kitchen, the basis would now be $300,000, and the gain on its sale for $450,000 would be $150,000 ($450,000 − $300,000).

How Much Would My Capital Gains Tax Be?

For illustration only, assume a 15 percent federal long-term capital gains rate and a 5 percent state tax rate. (Actual taxes may be lower or higher depending on your taxable income, state, the type of property, depreciation, and other factors.)

Using those assumptions, the tax on $200,000 of gain would be about $40,000.

Avoiding Capital Gains Tax

Fortunately, when you inherit real estate, the property’s tax basis is “stepped up,” which means the value is readjusted to its current market value and often reduces or entirely eliminates the capital gains tax owed by the beneficiary.

For example, Sally’s parents purchased a house years ago for $100,000 and bequeathed the property to Sally when they pass away. When Sally inherits the property, it’s now worth $200,000.

Below are a few scenarios for how much profit from the sale of the house would be subject to capital gains taxes.

Sally Sells the Property Immediately

Sally receives a step-up from the original cost basis from $100,000 to $200,000 (the value at the time of her parents’ death). If she sells the property for approximately $200,000, she generally would not have a capital gain, although selling costs and other adjustments could affect the calculation.

Sally Holds the Property and Sells the Property When It Appreciates

Several years pass, and the real estate is now worth $400,000. If Sally sells now, the difference between the stepped-up basis of $200,000 and the current value of $400,000 is subject to capital gains. In this case, Sally would generally have a $200,000 capital gain before accounting for selling expenses other adjustments. That gain may be subject to capital gains tax.

Sally Lives in the House and Sells When It Appreciates

If Sally owns the house and uses it as her main home for at least two years during the five-year period before the sale, she may be able to exclude up to $250,000 of capital gain from her taxable income. A married couple filing jointly may be able to exclude up to $500,000 if they meet additional requirements. Generally, the exclusion also cannot be used if Sally or her spouse claimed the home-sale exclusion for another home during the previous two years.

If the property sells for $400,000, Sally’s gain would be $200,000 because her stepped-up basis was $200,000. If she qualifies for the home-sale exclusion, she may be able to exclude the entire $200,000 gain.

The home-sale exclusion applies only if the inherited property becomes the beneficiary’s main home and the beneficiary meets the Internal Revenue Service (IRS) requirements. It does not automatically apply to every inherited property.

On the other hand, if Sally’s parents had gifted the same property to her before their deaths, as opposed to bequeathing it to her, the tax basis of $100,000 would not be stepped-up. Property received as a gift generally carries over the donor's adjusted tax basis rather than receiving a step-up to fair market value. Special rules may apply if the property was worth less than the donor's basis when it was gifted.

If Sally later sold the house for more than her adjusted basis, she would generally calculate her gain using the property’s $100,000 carryover basis, adjusted for improvements and other applicable changes.

Note that transferring a house during the owners’ lifetimes can have gift tax, estate tax, Medicaid planning, and other consequences. Families should consult an estate planning attorney before choosing between a gift, sale, trust, or inheritance.

Sally Chooses Not to Accept the House

Sally may decide that she does not want to inherit the house. This is called disclaiming an inheritance. If she follows the legal requirements, the house will pass to the next beneficiary, as if Sally had never inherited it.

Disclaiming an inheritance is not an automatic way to avoid taxes. Generally, Sally must refuse the property in writing within nine months and must not accept the property or any benefits from it before making the disclaimer. Because this decision can affect other beneficiaries, Sally should talk with an estate planning attorney first.

The next beneficiary may have tax consequences if that person later sells the house.

How Is the Cost Basis of a Property Determined?

The basis of inherited property is generally its fair market value on the owner’s date of death (although an alternate valuation date or other special rule may apply).

To determine the property’s tax basis, start by finding out how much the property was worth when the original owner died. The executor, personal representative, or estate attorney may have this information. If the value is unclear, you may need to hire a professional appraiser to determine the property’s fair market value.

An appraisal is often the most reliable way to document the property’s fair market value at the time of the original owner’s death. Keep a copy of the appraisal with your tax and estate records.

You may also be able to use the estate’s tax records or a written valuation from a qualified real estate professional. A tax assessment may be helpful, but it may not reflect the property’s full market value. If you are unsure which value to use, consult a tax professional before selling the property.

A written estimate from a real estate professional may provide useful information, but it may not be enough if the property’s value is disputed. When the value is significant or unclear, an appraisal is usually the safer choice.

Capital Gains Taxes in a Nutshell

Take care not to underestimate the impact of capital gains tax on inherited property. Inherited property is generally treated as long-term property for federal income tax purposes, even if you sell it shortly after receiving it. The applicable tax rate also depends on your taxable income, the type of gain, and potentially your state’s tax rules.

With proper planning, you may be able to reduce the tax on inherited property. Because tax laws and individual circumstances vary, consult an estate planning attorney or tax professional in your area before selling, gifting, or disclaiming inherited property.

Additional Reading

• Long-Term Care Costs Are Hollowing Out Generational Wealth
• 5 Things to Know to Reduce Your Capital Gains
• Is a Medicaid Patient’s Nursing Home Co-Pay Tax-Deductible?
• One Common Estate Tax Error That Could Cost You
• Will a Revocable Living Trust Reduce Your Estate Tax?