Inheriting property from a loved one can be both a financial opportunity and a legal challenge. While the emotional aspect of inheriting a family home can be overwhelming, the financial considerations are just as important.
One of the most significant concerns for heirs is the potential capital gains tax liability when selling the property. Without proper planning, a large portion of the profit from the sale could be lost to taxes.
The good news is that there are several legal strategies to avoid or reduce capital gains taxes on inherited property.
These include taking advantage of the stepped-up basis rule, using a 1031 exchange, converting the property into your primary residence, and more. This guide will explain each strategy in detail so you can make informed decisions and preserve your inheritance.
What is Capital Gains Tax on Inherited Property?
Capital gains tax is a tax on the profit made from the sale of a capital asset, such as real estate, stocks, or other investments. In the case of inherited property, this tax applies when the property is sold for more than its cost basis (the original purchase price or adjusted value).
However, there’s a key difference for inherited property: you don’t inherit the original purchase price as the cost basis. Instead, you benefit from the stepped-up basis, which is one of the most important concepts in reducing capital gains taxes on inherited property.
When Do You Owe Capital Gains Tax on Inherited Property?
You may owe capital gains tax if:
- You sell the property for a higher price than the stepped-up basis.
- You convert the property into a rental and later sell it for a profit.
- You delay selling the property and it appreciates in value.
By understanding when you owe taxes, you can take strategic steps to avoid or minimize them.
How Does the Stepped-Up Basis Rule Work?
The stepped-up basis rule allows the cost basis of an inherited property to be adjusted to its fair market value at the date of the previous owner’s death. This adjustment can significantly reduce or even eliminate capital gains taxes when the property is sold.
Example of How the Stepped-Up Basis Works
Suppose your parent bought a house for $100,000 and its market value at the time of their death was $500,000. If you inherit the house and sell it for $510,000, your taxable gain is calculated as:
Sale Price – Stepped-Up Basis = Taxable Gain
$510,000 – $500,000 = $10,000 taxable gain
If the stepped-up basis did not exist, the gain would have been:
$510,000 – $100,000 = $410,000 taxable gain
This rule saves heirs thousands of dollars in taxes and is one of the most valuable tools for avoiding capital gains tax on inherited property.
| Scenario | Original Basis | Stepped-Up Basis | Sale Price | Taxable Gain |
| Without Step-Up | $100,000 | N/A | $510,000 | $410,000 |
| With Step-Up | N/A | $500,000 | $510,000 | $10,000 |
What Are the Best Strategies to Avoid Capital Gains Tax on Inherited Property?
Sell the Property Immediately After Inheritance
If you sell the inherited property soon after inheriting it, the market value is unlikely to have changed significantly from the stepped-up basis. Since capital gains tax is only owed on the increase in value from the stepped-up basis, selling it quickly can result in little to no taxable gain.
Convert the Property Into a Primary Residence
Another effective strategy is to move into the inherited property and make it your primary residence. If you live in the property for at least two of the last five years, you may qualify for the primary residence exclusion, which allows you to exclude up to $250,000 (or $500,000 for married couples) from capital gains taxes.
Utilize a 1031 Exchange
A 1031 exchange allows you to sell the inherited property and reinvest the proceeds into another “like-kind” property, deferring the capital gains tax. To use this strategy, you must identify the new property within 45 days and complete the purchase within 180 days.
Use Estate Planning Tools in Advance
Proactive estate planning can significantly reduce capital gains taxes. For example, property owners can place assets into an irrevocable trust. The trust can distribute property to heirs, while avoiding probate and minimizing tax liabilities.
Disclaim the Inheritance
If you disclaim an inheritance, you legally refuse ownership of the property. While this might seem counterintuitive, it can be useful in specific situations. By disclaiming the property, it passes to the next beneficiary (like a sibling or spouse), and you may avoid being subject to taxes.
How Do You Calculate Capital Gains Tax on Inherited Property?
Calculating capital gains tax on inherited property may seem complex, but it becomes manageable when broken down into clear steps. This process determines how much profit is taxable when the inherited property is sold.
The primary factor that influences the calculation is the concept of the stepped-up basis, which resets the property’s cost basis to its market value at the time of inheritance.
Step-by-Step Guide to Calculating Capital Gains Tax
- Determine the Stepped-Up Basis:
- The “stepped-up basis” is the market value of the property on the date of inheritance.
- Example: If a parent purchased the property for $100,000 but its value at death was $500,000, then $500,000 becomes the new cost basis.
- Find the Sale Price:
- This is the amount you sell the property for.
- Example: You sell the property for $550,000.
- Calculate the Taxable Gain:
- Subtract the stepped-up basis from the sale price.
- Calculation:
$550,000 (Sale Price) – $500,000 (Stepped-Up Basis) = $50,000 (Taxable Gain)
- Apply the Capital Gains Tax Rate:
- The rate depends on your income and how long you held the property.
- If the property is sold after more than one year, you pay long-term capital gains tax at a rate of 0%, 15%, or 20%, depending on your income bracket.
- If sold within one year, short-term capital gains tax applies, which is taxed at the same rate as your ordinary income.
Example Calculation
| Stepped-Up Basis | Sale Price | Taxable Gain | Tax Rate (15%) | Capital Gains Tax |
| $500,000 | $550,000 | $50,000 | 15% | $7,500 |
In this case, the capital gains tax on a $50,000 gain at a 15% tax rate would be $7,500.
What Are the Tax Implications When Selling Inherited Property?
Selling inherited property has important tax implications that you need to be aware of. Unlike other property sales, inherited property benefits from the stepped-up basis rule, which often reduces the taxable gain. However, there are still tax obligations you must fulfill.
Capital Gains Tax (If the Property Is Sold)
If you sell the property for a profit, you’ll owe capital gains tax on the difference between the sale price and the stepped-up basis. The rate you pay depends on how long you hold the property before selling:
- Short-Term Capital Gains Tax: If you sell within one year, you’ll be taxed at your ordinary income rate (up to 37%).
- Long-Term Capital Gains Tax: If you hold the property for more than a year, you’ll pay a rate of 0%, 15%, or 20%, depending on your income.
Filing IRS Forms for Inherited Property Sales
When selling inherited property, you must report the sale to the IRS using these forms:
- Form 8949: Used to report sales of capital assets, including inherited property.
- Schedule D: Summarizes capital gains and losses from all investment property sales.
State Taxes on Inherited Property
Some states also impose their own capital gains tax, which varies from one state to another. Check local tax laws to see if you owe additional taxes.
When Are Capital Gains Taxes Due?
Capital gains taxes are due in the year the property is sold. If you sell the property in 2024, the taxes will be due with your 2024 federal tax return, usually by April 15, 2025.
How Does the 1031 Exchange Work for Inherited Property?
A 1031 exchange is a powerful tool that allows you to defer capital gains taxes when you sell inherited property and reinvest the proceeds into another like-kind property. This strategy is widely used by real estate investors.
How a 1031 Exchange Works?
- Sell the Property: You sell the inherited property, but instead of cashing out, you place the funds into a third-party intermediary account.
- Identify a New Property: Within 45 days, you must identify a new “like-kind” property that you intend to purchase.
- Reinvest the Proceeds: You have 180 days to close on the purchase of the new property.
- Defer Capital Gains Tax: By reinvesting, you defer the taxes until you sell the new property.
Benefits of a 1031 Exchange
- Tax Deferral: You won’t owe capital gains taxes until the new property is sold.
- Investment Growth: You can grow your real estate portfolio using deferred tax funds.
What Are the Most Common Mistakes When Dealing With Capital Gains on Inherited Property?
- Holding the Property Too Long: Delaying the sale of the property could lead to higher taxes. As the property value appreciates, the capital gains tax increases as well. Selling soon after inheritance is often the best move.
- Ignoring the Stepped-Up Basis: Many people don’t realize that inherited properties receive a stepped-up basis. This mistake can lead to overpayment of taxes, especially if heirs mistakenly use the original purchase price to calculate capital gains.
- Failing to Use a 1031 Exchange: Some heirs fail to take advantage of a 1031 exchange, which could allow them to defer taxes on a profitable sale. Without proper guidance, you may lose out on a valuable tax-saving opportunity.
- Not Getting Professional Advice: Real estate laws, tax rates, and rules around inherited property vary by state. Without consulting a tax professional, you could miss out on key tax-saving strategies.
Why Should You Consider Estate Planning to Avoid Capital Gains Tax?
Estate planning is not just for the wealthy. By planning ahead, you can transfer property to heirs while minimizing capital gains tax and other estate-related costs.
- Use Trusts to Avoid Probate: Trusts, especially irrevocable trusts, can transfer property ownership without going through probate. This reduces administrative costs and speeds up the transfer process.
- Gifting Property Before Death: Some property owners “gift” the property to heirs before they die, but this can be risky. Gifting transfers ownership at the original cost basis, not the stepped-up basis, so the recipient could face larger taxes.
- Minimize Estate Taxes: Proper planning can reduce or eliminate estate taxes, which are separate from capital gains taxes. Using life insurance policies and trusts can help heirs pay estate taxes.
Conclusion
Avoiding capital gains tax on inherited property is possible with the right strategies. From using the stepped-up basis to leveraging a 1031 exchange, heirs have several options to reduce their tax burden.
Additionally, effective estate planning can help transfer property to heirs in a way that avoids probate and minimizes taxes.
If you’re dealing with an inherited property, consider seeking advice from a tax professional or estate planner. By planning ahead, you can keep more of your inheritance and avoid costly mistakes.
Frequently Asked Questions (FAQs)
What is the stepped-up basis for inherited property?
The stepped-up basis adjusts the property’s cost basis to its fair market value at the time of inheritance, reducing or eliminating capital gains taxes when you sell it.
Can I live in an inherited property to avoid capital gains tax?
Yes, if you live in the property as your primary residence for at least 2 out of 5 years, you may qualify for the primary residence exclusion.
How does a 1031 exchange work for inherited property?
A 1031 exchange allows you to defer capital gains taxes by selling the property and reinvesting the proceeds into another “like-kind” property.
What forms do I need to file with the IRS after selling inherited property?
You must file IRS Form 8949 and Schedule D to report capital gains from the sale of an inherited property.
How soon should I sell inherited property to avoid capital gains tax?
Selling the property shortly after inheritance can help avoid capital gains since the sale price will be close to the stepped-up basis.
Do I have to pay state taxes on inherited property?
Yes, some states impose their own capital gains tax on inherited property, in addition to federal taxes. Check your state’s tax laws for specific requirements.
