How To Avoid Capital Gains Tax on Inherited Property

Home Insurance & Taxes, Homes, Selling a House

Inheriting a home from a loved one can be a gift … and a challenge. There are plenty of ways to put inherited assets to good use, but capital gains taxes may put a damper on your plans. 

Understanding how capital gains taxes work can help you decide whether to move in, sell the property or gift it to a loved one. We’re going to tell you what you need to know about capital gains taxes on inherited real estate and the tax implications of inheriting a house. 

What Is the Capital Gains Tax on Inherited Property?

Capital gains tax is the tax you pay on the profit you make from the sale of an asset. The tax only applies when you sell the asset (think: houses, stocks, jewelry, etc).

When you inherit property, it becomes an asset you can sell, keep or gift to someone else – and you may be able to avoid paying capital gains tax when you sell. 

Because the IRS implements capital gains taxes on a stepped-up basis with inherited property,[1] the property’s tax basis (typically the fair market value) is typically set the day you inherit the home. In nonfinance-speak, that means the IRS will adjust the value of the home to its value on the day you inherited it, not the day your loved one bought it.  

If you sell the house at its existing market value as soon as you inherit it, you won’t owe anything in capital gains taxes. If you hang on to the house and it increases in value, you’ll pay capital gains tax on the difference between the home’s sale price and its tax basis.

What you pay in capital gains taxes will vary based on your federal income tax rate and how long you’ve held the property. Depending on your tax filing status and taxable income, you’ll pay 0%, 15% or 20% on the profit from the sale if you kept the property for more than a year.[2]

You could be paying 10%, 12%, 22%, 24%, 32%, 35% or 37% on the profit from the sale if you hung on to the property for less than a year.[3] 

How Do You Calculate Capital Gains on Inherited Property?

There are a few different factors you’ll need to consider when you’re calculating the capital gains tax you may pay on the inherited property, including:

  • Value of the property: The value of your property is its sales price. This amount is key to determining whether you’ll pay capital gains tax and, if so, how much you’ll pay. 
  • Tax basis in the property: Your tax basis is not the home’s original purchase price. It is the home’s fair market value either on the date you inherit it or a date set by the estate’s executor. You subtract the tax basis from the sales price to determine the amount you’ll pay in capital gains tax. 
  • Tax rate: If you owe capital gains tax on inherited property, your tax rate will be based on how long you’ve held the property, your filing status and your tax bracket. Keep the house for less than a year, and you’ll pay short-term capital gains tax at 10%, 12%, 22%, 24%, 32%, 35%, or 37%. Keep the house for more than a year, and you’ll pay long-term capital gains tax at 0%, 15%, or 20%.

Let’s say you inherit a home from a grandparent. The home’s fair market value (or tax basis) is $500,000. And now you have to decide. Do you sell the home ASAP or hang on to it for a while? If you sell the home at its fair market value ($500,000) as soon as you inherit it, you won’t need to pay capital gains tax. 

But if you hang on to the property for 8 months and then sell it for $550,000, you’ll pay short-term capital gains tax. 

To calculate your capital gains tax, subtract the home’s fair market value ($500,000) from the sales price ($550,000). For tax purposes, you’ll only pay capital gains tax on the $50,000 you made in profit. Next, multiply the $50,000 by your income tax bracket. If you sold the house in 2022, based on your tax bracket, you could owe: 

  • $50,000 x 10% = $5,000
  • $50,000 x 12% = $6,000
  • $50,000 x 22% = $11,000
  • $50,000 x 24% = $12,000
  • $50,000 x 32% = $16,000
  • $50,000 x 35% = $17,500 
  • $50,000 x 37% = $18,500

Keep in mind that your filing status will also affect these calculations. 

If you waited a year or longer before you sold the home and made the same amount in profit ($50,000), you would use the following percentages to calculate your capital gains tax:

  • $50,000 x 0% = $0
  • $50,000 x 15% = $7,500
  • $50,000 x 20% = $10,000

By the way, this works the other way around, too. If you sell the home for less than its fair market value at the time of inheritance, you can claim a capital loss deduction on your tax return.

Capital Gains vs. Inheritance Tax

Capital gains are federal taxes that apply when you sell inherited property for profit. Inheritance tax (estate tax) only applies in certain states but is levied on any inherited property.

5 Ways To Avoid Capital Gains on Inherited Property

Who wouldn’t want to avoid or reduce capital gains tax if they could? Fortunately, there are a few ways to avoid capital gains taxes on inherited property.

1. Sell the property quickly

Selling the property before it increases in value can increase your chances of avoiding capital gains taxes. If you don’t see the home as a long-term investment opportunity, this is likely the best route for you. 

But no matter how quickly you sell, you will be on the hook for short-term capital gains taxes if you profit from the sale. You’ll need to weigh the risk of paying short-term capital gains taxes against the reward of turning a profit.

2. Disclaim the property 

Disclaiming a property lets you pass your ownership of a property to someone else. This can be the next person in the line of inheritance, another person of your choosing or even the state. Disclaiming a property is a drastic option that can’t be undone. Once you disclaim the property you forfeit your right to have any say in the property. If selling or maintaining the property feels like it could be more headache than it’s worth, this may be an option to consider.

State and local laws will dictate when and how you can disclaim property. You’ll usually have 9 months from the date of inheritance to disclaim the property. If you miss the deadline, you’ll remain the owner of the property.

3. Take ownership

If you make the inherited property your primary residence and live there at least 2 years before you sell it, you can qualify for an IRS capital gains exclusion (aka the Section 121 Exclusion). It’s $250,000 for a single filer or $500,000 for a couple filing jointly.[4] Many people who inherit homes typically choose to keep their homes to temporarily save on the cost of housing. And when they’re ready to sell, they get a large tax exclusion that shrinks their capital gains tax bill.

4. Convert to a rental property

Increasing demand for rental housing has made rental properties a hot commodity. Turning an inherited property into a rental property can be a great opportunity to generate a secondary or even primary income. 

If you eventually sell the property and make a profit, you’d be responsible for capital gains tax at that time unless you opted for a 1031 exchange (aka a like-kind exchange). This option lets you avoid capital gains tax as long as you use the proceeds from the sale to purchase another investment property.[5]

5. Deduct selling expenses

If you need to invest money into the home to sell it, you can reduce the amount you pay in capital gains tax by deducting these expenses, including home renovations, expenses tied to the sale of the home and what you spent hiring someone to help sell the property.

Alternatives to Inheritance

Another way to try and avoid capital gains taxes is to discuss estate plans with your loved one. Planning with someone who intends to leave you their property may help you avoid or reduce any associated taxes.

Gift the home before the owner’s death

Homeowners can take advantage of a variety of approaches to gift a home while they are alive. They can simply give it to you as a gift, in which case they will need to file IRS Form 709. The gift giver won’t pay gift tax as long as they don’t exceed the $12.06 million maximum lifetime gift exemption.[6] They can sell you the home at a significant loss, but they typically can’t deduct the loss on their taxes. 

Become a joint owner

Another way to gift a home to someone is to simply add their name to the deed. This creates a joint tenancy or joint mortgage. You and the homeowner would share ownership and be responsible for the home.

What do you need to sell an inherited property?

You’ll need all the usual paperwork associated with selling a home, and you may need permission from the executor of the estate to sell the property.

Is there a time limit to sell an inherited property?

No, there is no time limit to sell the property. But if you want to avoid capital gains taxes, sell it quickly so the property’s fair market value won’t have time to go up.

Do you have to report the sale of the inherited property to the IRS?

Yes, you must report the sale of the inherited property to the IRS. You can report the sale using IRS Form 1040 or Form 8949.

Don’t Inherit Alone

Consider all your options before you decide what to do with your inherited property. If you feel overwhelmed by your choices, consult an estate or wealth planner, financial advisor and tax professional. This way, you can make an informed decision with the help of experts.

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