If you inherit a house, stocks, or other property, you generally do not owe capital gains taxes simply because you received it. Taxes may come into play later if you sell the property for more than its adjusted tax basis. Inherited retirement accounts (401(k), IRA, etc.) have a different set of tax rules that apply to them that is not covered here.
Fortunately, inherited property generally receives a “step-up” in basis. This means the tax value is usually adjusted to the property’s fair market value when the original owner dies. As a result, you may owe little or no capital gains tax if you sell the property soon after inheriting it.
What Is Capital Gain?
Capital gain is the difference between the “basis” in property — usually real estate or stocks, but also including artwork and collectibles — and its selling price. The basis is usually the purchase price of property.
If you purchased a house for $250,000 and sold it for $450,000, you would have $200,000 of “gain” ($450,000 − $250,000).
However, the basis can be adjusted if you spend money on capital improvements. For instance, if after buying your house you spent $50,000 updating the kitchen, the basis would now be $300,000, and the gain on its sale for $450,000 would be $150,000 ($450,000 − $300,000).
How Much Would My Capital Gains Tax Be?
Capital gains tax rates are often different than ordinary income. The actual rate varies depending on your taxable income, state, the type of property, deductions, depreciation, and other factors. For illustration purposes only, if we assume the combined tax rate was 20%, then the tax on $200,000 in capital gains would be $40,000.
Avoiding Capital Gains Tax
Fortunately, when you inherit real estate, the property’s tax basis is “stepped up,” which means the value is readjusted to its current market value as of the date of death 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 parents’ death). If she sells the property for approximately $200,000, she generally would not have a capital gain, although selling costs and other adjustments could affect the calculation.
Sally Holds the Property and Sells the Property When It Appreciates
Several years pass, and the real estate is now 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 would generally have a $200,000 capital gain before accounting for selling expenses other adjustments. That gain may be subject to capital gains tax.
Sally Lives in the House and Sells When It Appreciates
If Sally owns the house and uses it as her main home for at least two years during the five-year period before the sale, she may be able to exclude up to $250,000 of capital gain from her taxable income. A married couple filing jointly may be able to exclude up to $500,000 if they meet additional requirements. Generally, the exclusion also cannot be used if Sally or her spouse claimed the home-sale exclusion for another home during the previous two years.
The home-sale exclusion applies only if the inherited property becomes the beneficiary’s main home and the beneficiary meets the Internal Revenue Service (IRS) requirements. It does not automatically apply to every inherited property.
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. Property received as a gift generally carries over the donor’s adjusted tax basis rather than receiving a step-up to fair market value. Special rules may apply if the property was worth less than the donor’s basis when it was gifted.
If Sally later sold the house for more than her adjusted basis, she would generally calculate her gain using the property’s $100,000 carryover basis, adjusted for improvements and other applicable changes.
Note that transferring a house during the owners’ lifetimes can have gift tax, estate tax, Medicaid planning, and other consequences. Families should consult an estate planning attorney before choosing between a gift, sale, trust, or inheritance.
How Is the Cost Basis of a Property Determined?
The basis of inherited property is generally its fair market value on the owner’s date of death (although an alternate valuation date or other special rule may apply).
To determine the property’s tax basis, start by finding out how much the property was worth when the original owner died. The executor, personal representative, or estate attorney may have this information. If the value is unclear, you may need to hire a professional appraiser to determine the property’s fair market value.
An appraisal is often the most reliable way to document the property’s fair market value at the time of the original owner’s death. Keep a copy of the appraisal with your tax and estate records.
You may also be able to use the estate’s tax records or a written valuation from a qualified real estate professional. A tax assessment may be helpful, but it may not reflect the property’s full market value. If you are unsure which value to use, consult a tax professional before selling the property.
A written estimate from a real estate professional may provide useful information, but it may not be enough if the property’s value is disputed. When the value is significant or unclear, an appraisal is usually the safer choice.
Planning for Capital Gains Taxes
Take care not to underestimate the impact of capital gains tax on inherited property. As part of a comphrensive estate plan, an experienced estate planning attorney can advise you on how best to create a plan that helps save your heirs on taxes. With the increasing values of real estate on Long Island, this is even more important than ever. Trusts can also impact capital gains taxes, so it is essential to use an attorney that knows the proper way to establish a trust for your home to ensure it is eligible to receive the step-up in basis.
Contact the estate planning attorneys at Kurre Schneps to learn how, with proper planning, you may be able to reduce the tax on inherited property.
