What To Know About the Capital Gains Tax on Inherited Property

Inheriting a house raises many questions: Should you keep or sell the property? Are there outstanding debts tied to the home? But another important factor to consider is the capital gains tax on inherited property. This tax can result in a hefty bill if you decide to sell the house. Here’s what to know.

Key takeaways

• You may owe capital gains taxes when you sell inherited property.
• Your capital gains tax rate will depend on how long you own the property before selling it.
• Selling the house quickly can help minimize the capital gains tax.

What is the capital gains tax?

When you earn a profit from the sale of an asset, like real estate or stocks, you generally must pay capital gains taxes. For example, if you buy a stock for $50 and sell it for $100, you will owe capital gains tax on the $50 profit you made from selling your stock.

Do you pay capital gains tax on an inherited property?

You may have to pay capital gains taxes if you choose to sell an inherited home. One of the most important concepts to understand when it comes to the taxation of inherited property is the IRS’ step-up in basis rule. Below, we break down this rule and what it means for your tax situation.

Step-up tax rule

The step-up tax rule can help minimize the taxes you owe when selling an inherited property. This tax provision adjusts the home’s cost basis, or the original cost of the property (plus any home improvements) which is used to determine the amount of capital gains taxes due when the property is sold.

When you inherit a home, you receive a “stepped-up basis.” This means that the cost basis is “stepped up” to the home’s fair market value on the date of the prior owner’s death, and this is the basis used to calculate your capital gains tax.

Example

Let’s say you inherit a house from your mother, Anne, who paid $150,000 for it over 20 years ago. Anne put $30,000 of work into the home, meaning the cost basis is $180,000. When you inherit the house, its basis is “stepped up” to its fair market value on the date Anne died, which was $600,000. This means your cost basis in the home is $600,000, not $180,000.

If you sell the house for $620,000, you would subtract the basis from the sale price to get your capital gain (which is the amount you’ll have to pay taxes on).

$620,000 (sale price) – $600,000 (stepped-up basis) = $20,000 is your capital gain

Now, let’s take this one step further. Here’s what your capital gain would look like if the step-up rule didn’t exist.

$620,000 (sale price) – $180,000 (original basis) = $440,000 is your capital gain

How to avoid capital gains tax

Sell the house right away

One strategy to minimize capital gains taxes is to sell the inherited home as soon as possible. That way, you reduce the risk of major fluctuations in the property’s value between the date of the prior owner’s death and the sale. For example, if the home’s value is $400,000 on the date of death of the prior owner and you sell it shortly after, the value is likely to remain close to that amount, minimizing the amount of capital gain. If you wait too long to sell, the value could increase, resulting in a larger taxable gain.

 Learn more: How Can I Sell My House Fast?

Use the home sale tax exclusion

The IRS allows home sellers to exclude a certain amount of capital gains from the sale of their primary home. The exclusion is $250,000 for single tax filers and $500,000 for married couples who file their taxes jointly. In order to take advantage of this tax break, you would need to move into the inherited home and make it your primary residence for at least two years.

Disclaim the inheritance

You can also choose to decline the inheritance. The legal process of rejecting an inheritance is called “disclaiming an inheritance.” By doing so, you can avoid potential capital gains taxes on the sale of the home, but you will also forfeit any claim to the property.

Other considerations when inheriting a house

In most states, when you inherit a house, your name doesn’t go on the title immediately. The first step of settling an inheritance involves a probate court judge. The judge reviews the deceased person’s will and approves an executor who carries out the terms of the will.

As part of their duties, an executor will likely need to:

• Look into insurance. The homeowners insurance shouldn’t lapse. Make sure to bring or keep the premiums current.
• Identify any liens and maintain payments. Contact any lienholders to keep up with the payments on any outstanding debt. Liens could include a mortgage, second mortgage (home equity loan or line of credit), unpaid property taxes, unpaid taxes and homeowner association assessments.
• Address utilities. Cancel and/or reestablish utilities and services, at least temporarily, until the new owners take possession. These may include electricity, sewer, internet, cable, phone, lawn care and homeowners association (HOA) dues.
• Order an appraisal. A home appraisal will determine what the home is worth, which can influence the taxes inheritors face.
• Research property taxes. Property taxes may or may not be included in the mortgage. Annual property taxes may be due, or the house may have unpaid property taxes.
• Find and allocate belongings. If the deceased person specified in their will that certain people inherit specific items in the house, the executor must find and ensure the correct people receive them.

At this point, the house is still considered an asset of the person who passed away. If that person had any outstanding debts, their assets could be used to repay those bills. As an inheritor, you have a “right to ownership,” but you don’t own the house until the title is in your name.

Steps to take when inheriting a house

1. Talk to the executor

The executor is a key figure in this process. It’s important to communicate with the executor to obtain information and coordinate the property transfer. Be sure to ask any questions you have about your rights and responsibilities tied to the property.

2. Talk with any co-inheritors

If you aren’t the sole heir to the house, talk with your co-inheritors. Gauge how they feel about selling versus keeping the property. You won’t be able to sell the property unless the other heirs agree, and someone will need to maintain the house until a decision is made. The best thing to do is find out who has a stake in the house and communicate early and often about everyone’s intentions and expectations.

Whether moving in, renting or selling, you may want to do repairs and renovations to bring the house up to date. Home improvement loans are available to finance these types of projects.

3. Get an appraisal

If the executor didn’t order one, consider getting an appraisal. Knowing the value of the property can influence your decision to keep or sell the home, and will give you a clearer idea of what to expect tax-wise if you choose to sell.

4. Evaluate any debts owed

Ensure that a thorough title search is done on any liens that claim the property as collateral. If the house still has debts against it or a tax lien, find out how much is owed and what the payments are. Evaluate the property’s total debts compared to its financial value and any emotional value it may have for you and your family.

5. Consider getting professional advice

Professionals can help clear complications and confirm any debt associated with the house, the taxes you’ll owe as the heir, and how buying, selling or turning it into a vacation home will impact your finances. Professionals you should consider consulting include lawyers (preferably with estate planning and real estate expertise), estate planners, accountants, financial advisors, trust officers and philanthropic consultants.