How is capital gains tax calculated on inherited property

• HOME
• ESTATE PLANNING

• October 28th, 2020

When you inherit property, such as a house or stocks, the property is usually worth more than it was when the original owner purchased it. If you were to sell, there could be huge capital gains taxes, which could cost you thousands of dollars.

Avoiding Capital Gains Tax

Fortunately, when you inherit real estate, the property's tax basis is "stepped up," which means the value is re-adjusted 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 parent's death). If she sells the property right away, she will not owe any capital gains taxes.

Sally Holds the Property and Sells When the Property Appreciates

After a few years, the real estate is 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 will pay capital gains tax on $200,000.

Sally Lives in the House and Sells When the House Appreciates

If Sally lives in the house for at least two years before selling, Sally can exclude up to $250,000 ($500,000 for a couple) of her capital gains from taxes. If the property sells for $400,000, she would be able to exclude the $200,000 in appreciation (the difference between the sale value and the stepped-up basis) that would otherwise be subject to capital gains.

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. If Sally sold the house, she would have to pay capital gains taxes on the difference between $100,000 and the price when she sold it.

Sally Disclaims the House to Avoid Taxes

Sally chooses not to inherit the real estate and ensures that she won't pay taxes on the property next year. The house will then go to the next beneficiary in line.

Capital Gains Taxes in a Nutshell

Take care not to underestimate the impact of capital gain tax on inherited property. The capital gains tax rate will depend on the length of time that you hold the property; long-term rates apply if you hold the property for more than one year.

With proper planning you can avoid paying high capital gains taxes on assets you inherit. If you have inherited property or anticipate that you will, the advice of an estate professional is invaluable. Contact an estate planning attorney in your area to learn more about how capital gains taxes can affect you.

Last Modified: 10/28/2020

Capital gains tax is due on the sale of all real estate unless the homeowners qualify for a tax exclusion or deferral. The tax rate ranges from 15% to 20% federally and 5.2% to 12% in Massachusetts. As you can imagine, this can add up to quite a bit of money. It’s important to understand capital gains tax on inherited properties and how you may be able to avoid or reduce your tax liability.

How Capital Gains Is Calculated

It’s a common misconception that taxes are due on the sale price of a property or the money you receive in cash from the sale. Taxes actually only apply to the “gain” or profit from the sale. How this is calculated can be a bit complex. In its simplest form, you take the sale price and subtract the tax basis to determine the gain. So, if you sell a property for $400,000 and the tax basis is $250,000, then you owe tax on the $150,000 gain.

Tax Basis for Inherited Properties

The complicated part is calculating the tax basis. It starts with the purchase price, plus the cost of improvements, less depreciation and selling expenses, and various other factors. Fortunately, for inherited properties, the calculation is more straight forward.

Let’s assume you inherit a property from a relative with a tax basis of $250,000. That amount is “stepped up” to reflect the property’s value on the date of death. If the market value is $400,000, you would only pay taxes on anything you receive above and beyond that. It’s also possible that you might report a loss if it’s sold for less. The cash you receive at closing is completely separate from your taxable gain or loss.

Reducing or Deferring Capital Gains

There are a few ways that you might be able to avoid or reduce capital gains on an inherited property.

Option 1 – Sell It Right Away

Because the stepped-up tax basis of an inherited property reflects the market value on the date of death, selling it quickly (before market values increase) can avoid or reduce capital gains tax. However, it doesn’t make sense to rush a sale simply to avoid the tax. The tax is only on a portion of the gain. You still benefit from the remainder of that gain (which is more than the tax).

Option 2 – Make it a Primary Residence

A tax exemption is allowed for primary residences. If you live in the home for at least 2 of the last 5 years before selling it, you may qualify. The amount exempted is $250,000 of gain for single tax filers and $500,000 for married filers. Using this exemption can be helpful if you owned a property for a long time and there’s quite a bit of gain as a result. For instance, perhaps you inherited a property 10 years ago and market values have gone up by $300,000 since then. You could save $66,000 to $96,000 in capital gains taxes.

Option 3 – Use a 1031 Exchange

Another option is a 1031 Exchange, often referred to as a tax-deferred exchange. If you keep an inherited property as an investment/rental and later wish to sell it, you can defer taxes but rolling the gain into the purchase of a like-kind property (i.e., another investment property). Taxes would not be due until you sell that new property. Of course, it could also be deferred again by completing yet another 1031 Exchange.

Summary of Capital Gains Tax on Inherited Properties

We’ve seen cases where homeowners sell an inherited property and spend the proceeds, only to find out next year (when filing taxes) that they owe a large sum of capital gains. Don’t let this catch you by surprise and create a financial burden. Consult with an accountant or tax advisor before selling an inherited property. Also consider the above methods for reducing or deferring taxes. Knowing your options and what to expect will allow you to save money and make better decisions.

If you are concerned about tax burdens that your heirs may face, contact our team to discuss your estate plan. There are different ways to gift a home to your children, each with different benefits and tax consequences. We can help you select the right one for your family.

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