A piece of property is probably one of the most valuable gifts you’ll receive. Whether it’s a family vacation home or the house you grew up in, the inherited property can help you build your own financial portfolio and provide you with financial flexibility. However, this gift might also come with paying responsibilities for the recipient—you.
Do you pay capital gains tax on inherited property? The answer is yes, but typically only if and when you sell the property.
However, when selling your home, some complex factors determine how much you’ll pay in taxes, when you’ll pay it, and how you might be able to defer or exclude the capital gains tax. Keep reading to learn more about inherited property and capital gains taxes.
When Do You Pay Capital Gains On An Inherited Property?
If you inherit property, you don’t have to pay a capital gains tax until you sell the plot. However, in some states, the total estate of the deceased may be subject to an estate or inheritance tax.1 Some states only tax high-value estates while others charge a tax on any inheritance. Often, the spouse and relatives of the deceased are exempt from the inheritance tax. Yet, it all depends on location so it is important to learn the tax rules in your state for inherited property.
So, if you inherit your parents’ home after they’ve both passed away, and you live in a state that doesn’t charge an estate or inheritance tax, you wouldn’t pay any additional taxes right away. If you don’t keep the home and instead decide to sell it, then you might have to pay a capital gains tax. In the case that the tax amount is too high for you to pay and you don’t declare it, some consequences might include penalties and fines.
What Is a Capital Gains Tax?
A capital gains tax is applied to the profit you make from selling a capital asset, such as real estate. 2For example, if you buy a home for $150,000 and sell it for $300,000 a decade later, your capital gain would be $150,000. However, this doesn’t mean you’ll pay tax on the full $150,000 profit—other factors go into calculating the capital gains tax. And like income tax, capital gain is a form of taxable income, hence the capital gain tax.
How Is Capital Gains Tax Calculated?
On the surface, the formula is a simple matter of subtraction to calculate capital gains to which a tax is applied. However, several factors influence whether you pay capital gains tax on inherited property, including:
- How long you’ve owned the property
- Your income and marital status
- If you live in the home
- The condition of the property
Let’s take a look at how each of these impacts the amount of tax you’ll pay when you sell an inherited property.
Ownership: Short-Term vs. Long-Term
If you’ve owned a property for less than a year and make a profit when you sell it, it’s considered a short-term gain.3 Typically, short-term gains are taxed at a higher rate than long-term gains.
Luckily, capital gains taxes for an inherited property are always assessed as though it were a long-term gain, even if you own the property for less than a year. To that end, long-term capital gains are taxed between 0% to 20% depending on your income and marital status, making the tax basis more adjustable.
Residency Rule, Marital Status, and Income
If, after you inherit a home, you decide to make it your permanent residence before selling it, you may qualify for a capital gains tax exemption after living in the home for two years. When selling the home, this exemption includes:
- Single people – If you’re single, you can exempt up to $250,000 in capital gains on a sale of a home you’ve lived in for at least two years.
- Married couples – As a married couple, you can exempt up to $500,000 in capital gains on the sale of your home.
As such, this rule may allow you to exempt all of the capital gains on inherited property, depending on its value when sold.
Home Condition: Cost Basis and Adjusted Cost Basis
The last factor that contributes to the amount of capital gains tax you incur is the value and condition of the home or property you inherit. Two elements influence the capital gain of a home when sold:4
- Cost basis – In capital gains terminology, the cost basis is the price paid for the property, including any fees or commissions. However, over time, a property’s value may decrease or increase based on several factors, such as whether upgrades were made to the property. That’s where the adjusted cost basis comes in.
- Adjusted cost basis – The adjusted cost basis is how much the home is worth when you sell it. If you’ve added $60,000 of value to your home through upgrades, then your adjusted cost basis would be the amount you paid to buy the home, plus the upgrade value. The sales price is then what you receive for the sale of the home, minus any commissions or fees you paid at the time of the sale.
If the property’s value stays consistent, the cost basis is used to determine the capital gain. However, if the value increases or decreases, the capital gain is then calculated by subtracting the adjusted cost basis from the total sales price. This determines whether taxes are owed or offset.
Cost Basis For Inherited Property
Now that you have a basic understanding of how capital gains taxes are calculated, let’s look at some specific factors pertaining to the sale of inherited property and how they differ from other capital gain situations:
- Fair market value (FMV) – Instead of relying on the original cost basis of the home to determine the capital gain, the FMV at the time of the owner’s death is used as the new cost basis for all calculations.
- Stepped-up basis – When your inherited property’s cost basis is calculated at FMV instead of the original purchase price, this is known as the stepped-up basis.
For example, your parents originally purchased their home for $60,000 forty years ago, but at the time of their deaths, it was worth $350,000. Instead of using the lower amount, which might stick you with a huge tax bill, the cost basis for determining capital gains would be $350,000.
Avoiding the Capital Gains Tax On Inherited Property
There may also be situations in which you can avoid the capital gains tax on an inherited property entirely. Ultimately, your financial situation will dictate which option is best for you and your family. The methods you can use to prevent a capital gains tax bill include:
Option 1: Disclaim the Inheritance
By disclaiming the inherited asset, you legally state that you don’t want the property.5 This action is binding and can’t be undone, so you must be certain that you don’t wish to receive the inheritance property before disclaiming it.
If you disclaim the property, the next person in the will would inherit it instead. There are several reasons you might choose to disclaim their inheritance, including:
- You don’t want to pay property taxes or upkeep on the home
- Capital gains taxes would interfere with your finances
- Your personal relationship with the deceased wasn’t positive
Regardless of your reason, this is the most drastic approach to avoiding capital gains. Luckily, several other options are less severe.
Option 2: Sell Right Away
If you’re worried about how much you’d foot, you might be wondering, “How can I avoid capital gains tax on a home sale?” You can elect to sell the inherited property right away. This prevents any further appreciation of the home, which limits the capital gains tax you’ll need to pay. For example, if the property’s FMV is $250,000 and you sell it for $275,000, you would pay between $3,750 and $5,000 in taxes.
If you waited two years to sell the home and the value increased, you might be able to sell the home for $310,000. You’d then have a bigger tax bill of between $9,000 and $12,000. While you’d be making more of a profit from the sale, you’d be paying more in taxes.
Additionally, you may not want the hassle of caring for the property for two years before getting it off your hands.
Option 3: Make it Your Primary Residence
Waiting at least two years to sell the property is advantageous if you’re willing to make it your primary residence for that time. To that end, if you live in the home for at least two out of five years, you might qualify for a capital gains tax exemption. This means you can sell the home and won’t have to pay capital gains taxes on:
- Up to $250,000 of profit for single people
- Up to $500,000 of profit for married couples
This is a significant benefit for you as it allows you to make a hefty profit tax-free.
Option 4: Rent Out the Property
Finally, you can defer paying capital gains taxes indefinitely if you keep the home as an investment property. This allows you to rent out the home and earn money from renters while avoiding the capital gains tax until it’s more beneficial to you—when it’s a good time, you can sell the home and pay the tax.
Keep in mind that you’ll have to pay income taxes on the money you make from collecting rent. You’ll also be responsible for paying property taxes and maintaining the property as long as you own it.
Option 5: Apply for a 1031 Exchange
If you are a first-time property owner, this might be the first time you’ve read about a 1031 exchange. What is a 1031 exchange property, you may ask? It is the trade of one investment property for another one that has similar value. A 1031 exchange allows property investors to defer the capital gains tax. Normally, a primary residence doesn’t qualify for a 1031 exchange, but many homeowners can take advantage of the loophole by converting the home to a rental property. But, what happens when you sell a 1031 exchange property? You have to purchase the replacement property within 180 days to qualify for a 1031 exchange. Only explore the possibility of a 1031 exchange when you are certain you can purchase the replacement within the given time frame.
Sell Property Hassle-Free with FlipSplit
Inheritance tax can be complex and messy. Sometimes you find you’re not in a financial position to absorb more taxes, or you just don’t want the hassle of dealing with a second property.
If you decide that selling the home you inherited is the right choice for you, FlipSplit can help.
We buy houses in any condition for cash. Then, we make repairs and upgrades meant to maximize the value of the home. When we sell the home, we split the profits with you. It couldn’t be easier.
Contact us to see how you can sell your home fast and stress-free today.
- AARP. 17 States with Estate or Inheritance Taxes. https://www.aarp.org/money/taxes/info-2020/states-with-estate-inheritance-taxes.html
- IRS. Topic No. 409 Capital Gains and Losses. https://www.irs.gov/taxtopics/tc409
- IRS. Publication 544 (2020), Sales and Other Dispositions of Assets. https://www.irs.gov/publications/p544
- Forbes. What is the Capital Gains Tax? https://www.forbes.com/advisor/investing/capital-gains-tax/
- Smart Asset. How to Avoid Paying Capital Gains Tax on Inherited Property. https://smartasset.com/taxes/how-to-avoid-paying-capital-gains-tax-on-inherited-property