Inheriting property can be a valuable financial windfall, but it may come with some tax obligations—most significantly capital gains tax if you sell the property for a profit. Luckily, tax planning and tax-minimizing techniques can minimize, or even eliminate, capital gains tax on the sale of inherited property.
Understanding how capital gains tax on inherited property functions and how to lawfully reduce your tax payments will enable you to derive maximum benefits from your inheritance.
Understanding Capital Gains Tax on Inherited Property
What Is Capital Gains Tax?
Capital gains tax is assessed when you sell an asset for more than its cost. For inherited property, capital gains tax is figured on the increase in value from the date you inherit the property until the date you sell it.
What Is the Step-Up in Basis?
The step-up basis rule reduces capital gains tax for inherited property. Instead of the initial cost, the new cost basis of the property is stepped up to the property’s fair market value (FMV) at the time it was inherited.
Example:
- If your parents bought a home for $100,000 but its FMV at the time you inherited it was $400,000, your cost basis is now $400,000.
- If you sell it for $420,000, you pay capital gains tax only on $20,000 and not on the whole appreciation from the original value.
This significantly reduces taxable gains and helps lower your tax burden.
How to Avoid Capital Gains Tax on Inherited Property
Sell the Property as Soon as You Inherit It
Since the property receives a stepped-up basis, selling it soon after inheriting it usually means minimal or no gain and, consequently, minimal or no capital gains tax.
Move into the Property and Use the Home Sale Exclusion
If you move into the inherited property and live there for at least two years as your primary residence, you can use the home sale exclusion:
Single filers: Excluded are up to $250,000 of capital gains
Married couples: Excluded are up to $500,000 of capital gains
You must qualify by:
- Owning the property for at least two years
- Living in the property as your primary residence for at least two of the last five years
This strategy avoids capital gains tax if the property increases in value over time.
Convert the Property to a Rental and Perform a 1031 Exchange
A 1031 exchange allows you to defer capital gains tax by selling the inherited property and putting the money into another investment property.
The key requirements for a 1031 exchange are:
- The inherited property must be converted into a rental property first
- The new property must be of equal or greater value
- The exchange must be completed within 180 days of the sale of the original property
By putting off taxes forever, you’re able to reinvest in property without incurring immediate capital gains tax.
Give the Property Instead of Selling It
If you give the property to a family member or heir as a gift, they receive the step-up basis when they sell it, which reduces capital gains tax.
However, gifting can trigger gift tax implications when the value of the property exceeds the IRS yearly gift tax exemption ($17,000 per donee in 2023). Consult with a tax advisor before choosing this option.
Give the Property to Charity
Donating inherited property to a qualified charity provides:
- A full tax deduction for the FMV of the property
- No capital gains tax on the sale of the property
- A potential reduction in estate taxes
This is the best approach if you want to give to charity and gain maximum tax deductions.
Wait Until Capital Gains Tax Rates Are Lower
If you can afford to wait to sell, wait until:
- Your income is lower since capital gains tax is income-based
- The property value stabilizes, which will reduce taxable gains
Holding the property for a longer period of time can reduce your overall tax liability.
Check If Your State Imposes Capital Gains Tax
Other states assess lower or no capital gains tax. Depending on your residence in a tax-friendly state, the sale of inherited property will incur fewer overall taxes.
Common Mistakes to Avoid
Selling Without Understanding the Step-Up Basis
Most heirs believe they must pay tax on the entire increase in value—but the step-up basis significantly reduces taxable gains.
Failing to Use a 1031 Exchange Timely
A 1031 exchange demands strict timeframes—failure to meet deadlines can lead to full capital gains tax exposure.
Failure to Consult a Tax Professional
Inheritance and property taxes are complicated. Consulting with a tax professional guarantees that you take full advantage of available tax exemptions and steer clear of expensive errors.
Reduce or Avoid Capital Gains Tax on Inherited Property
By being aware of step-up basis rules, tax exemptions, and strategic selling channels, you can effectively reduce or eliminate capital gains tax on inherited property. Regardless of whether you sell, live in, rent, or gift the property, these channels help you preserve your inheritance and lower tax outlays.
So, take a proactive approach, be aware of your options, and maximize your inherited property without unnecessary tax costs!