Inherited Home Taxes: Capital Gains Explained

When you sell an inherited home, capital gains tax is based on the difference between the sale price and your stepped-up basis, which is usually the fair market value at the decedent’s date of death. If you sell soon after inheriting, you may owe little or no tax because the IRS resets the basis to the current value. Any gain from later appreciation above that value becomes taxable.

Types of Taxes Associated with Inherited Property

There are three main types of taxes that apply to inherited assets.

• Estate Taxes – These are paid by the estate itself prior to any assets being passed along to beneficiaries. The government sets a minimum threshold, so not every estate will be impacted.
• Inheritance Taxes – While there is no federal inheritance tax, there are several states that impose a tax on the value of a deceased person’s estate once it’s passed on to an heir. 
• Capital Gains Taxes – These are taxes assessed on inherited assets once they are sold and will be the primary focus of this article. 

What Are Capital Gains Taxes and How Do They Work?

When someone sells an investment for more than its original purchase price, they will almost always be subject to capital gains taxes. 

Typically, you will hear about capital gains tax in the context of selling stocks, but it can also apply to property as well, including real estate that you inherit.

Under normal circumstances, capital gains tax is levied on the increase in value from the date of purchase to the date of sale. So, if you bought a stock for $10 and then you sold it for $15, you would owe capital gains taxes on the increase of $5. 

The rate you are taxed may vary based on how long you owned the asset. For instance, there are short-term capital gains, which apply to assets owned for less than one year. Assets held for a year or longer would fall under the category of long-term capital gains.

Capital Gains on Real Estate

The IRS offers some exclusions when it comes to capital gains on the sale of a home. For instance, let’s say you sell your home for a net profit of $350,000. If you qualify, you may be able to lower your tax burden by excluding a portion of that gain. 

The IRS website has some rules and worksheets that you can use to determine your eligibility. You may also want to speak to someone who is experienced in tax law.

How Are Capital Gains Calculated for Inherited Property?

With inherited property, taxes are assessed on what’s known as the “stepped-up” basis. This means that you would only be taxed on the difference between the sale price and the fair market value of the property at the time of the deceased owner’s death (not what they originally paid for it).

Example: 

Uncle Joe bought his home in 1990 for $100,000. At the time of his death, that property was worth $250,000. A year later, his niece, who inherited the home, sells it for $260,000. 

Since the “stepped-up” increase in value between the date of Uncle Joe’s death and the date she sold it is $10,000, that’s all she would be taxed on.

Now, let’s assume she was only able to sell the home for $250,000. In that case, she would not owe any capital gains, since the value of the home did not increase between the date of death and the sale date.

Capital Losses

Under certain circumstances, you might also be able to claim a capital loss on your taxes if you sold the property for less than its “stepped-up” value.

In order for this to be an option, you would need to meet certain criteria, such as that you have no personal relationship with the buyer (including the executor) and that neither you nor your siblings used or intended to use the property for personal purposes. 

This can get tricky, so it’s always best to consult with an experienced tax professional before claiming anything as a loss.

How do Capital Gains Taxes Work with Multiple Owners?

If you inherited the property with one or more other beneficiaries, the same rules apply. Capital gains taxes will be assessed on the “stepped-up” basis of the jointly owned property once it is sold, and the total due will be split among the co-owners based on each one’s ownership stake. 

How to Avoid Capital Gains on Inherited Property

Let’s face it. Nobody likes to pay taxes. Fortunately, there are a few options for eliminating, or at least minimizing, the amount you’ll own in capital gains on the home you inherited.

Sell the Property Quickly

In most cases, the sooner you sell inherited property, the lower your tax obligation will be. Again, this is because you are taxed based on the fair market value of the date of death, so the less time you hold onto the home, the less likely it will be to appreciate in value. 

The quickest and easiest way to sell an inherited home and avoid capital gains taxes is to work with a cash buyer. These types of transactions can be completed in just a few days.

Make the Home Your Primary Residence

A second option to avoid capital gains on inherited property is to live in the home for a few years before selling it. The IRS allows certain exclusions, provided you reside in the home for at least two of the five years preceding its sale.

Obviously, with this option, you would need to be comfortable moving into the home and living there for a while. This can also get tricky when there are multiple heirs.

Rent the Property Out 

An inherited home that is used as an investment property would still be subject to capital gains taxes upon its sale, however, you may be able to defer those taxes with a 1031 exchange, through which the proceeds of the sale would be used to purchase another similar property.

As usual, there are a number of rules and regulations that govern these types of in-kind transactions, so it’s strongly recommended that you consult with your tax advisor.  

Disclaim the Inheritance

The last option for avoiding capital gains taxes on an inherited property is to simply not inherit it in the first place. This is referred to as “disclaiming” the inheritance, and it’s something heirs sometimes choose to do when they don’t want to deal with all the taxes and other complications of inheriting a home.

If you choose to go this route, make sure you are certain that this is what you want. Once you’ve formally disclaimed, it cannot be undone, and whatever property you have forfeited will be gone.  

How and When Are Capital Gains Taxes Paid?

If you do sell the property and determine you are subject to capital gains (or losses), you would need to report it with your normal tax return. Keep in mind, this reporting would apply to the calendar year of the sale, not the year you actually inherited the home.

Here are the steps you would need to take:

1. Calculate your capital gain (or loss) by subtracting the “stepped-up” basis of the home from the sale price.
2. Report the sale on an IRS Schedule D form. 
3. Copy the gain (or loss) over to Form 1040. (Note: Forms 1040A and 1040EZ cannot be used in the year the property is sold.)
4. Attach Schedule D to your return and submit it to the IRS.