Inheriting a home or other property can increase the value of your estate but it can also result in tax consequences. If the property you inherit has appreciated in value since the original owner purchased it, you could be on the hook for capital gains tax should you choose to sell it. That could result in a large tax bill if thereâs a sizable gap between the original purchase price and the price youâre able to sell the property for. There are some possibilities for how to avoid paying capital gains tax on inherited property which are worth considering if youâre the beneficiary of an estate or trust
Capital Gains Tax, Explained
Capital gains tax applies when an investment is sold for more than its original purchase price. Typically, you might think about capital gains tax in terms of selling stocks or other securities you hold inside your investment portfolio. So if you bought a stock for $2 per share and sold it for $5 per share, youâd owe capital gains on the $3 in profit you realized from the sale.
The IRS taxes capital gains differently, depending on how long you hold the underlying asset. The short-term capital gains tax rate applies to investments or assets you hold for less than one year. The long-term capital gains tax rate applies to investments or assets you hold longer than one year.
Between the two, the long-term capital gains tax rate is more favorable. Short-term capital gains are taxed at your ordinary income tax rate, whereas long-term capital gains are taxed at 0%, 15% or 20% tax rates, based on your filing status and taxable income for the year. So if youâre in a higher tax bracket, it typically makes more sense to hold investments longer to minimize the amount of capital gains tax you owe.
Capital Gains Tax Rules for Inherited Property
When inheriting property, such as a home or other real estate, the capital gains tax kicks in if you sell that asset at a higher price point than the person you inherited it from paid for it. Likewise, itâs possible to claim a capital loss deduction if you end up selling the property at a loss.
The difference with inherited property, however, is that the IRS allows you to use whatâs known as a stepped-up basis for calculating capital gains tax liability. The step-up cost basis represents the value of the home when you inherit it versus its original purchase price.
For example, say your parents bought a home for $100,000 thatâs worth $400,000 by the time you inherit it. Under ordinary capital gains tax rules, youâd owe tax on the $300,000 difference between what your parents paid for it and its current value.
That could result in a huge tax bill for you, which is why the IRS allows you to use the stepped-up basis instead. Assume that you donât sell the home right away, for instance. You hold on to the property for two years, at which time you sell it for $450,000. Taking the step-up basis of $400,000 into account, youâd only pay capital gains on tax on the $50,000 in appreciation value.
That wouldnât allow you to completely avoid paying capital gains taxes on inherited property, but using the step-up cost basis can reduce the amount of capital gains tax youâd owe.
How to Avoid Paying Capital Gains Tax On Inherited Property
If you stand to inherit property and you want to avoid paying taxes on it, there are three possible options for minimizing or eliminating capital gains tax altogether. The first is to simply sell the property as soon as you inherit it. By selling it right away, you arenât leaving any room for the property to appreciate in value any further. So if you inherit your parentsâ home and itâs worth $250,000, selling it right away could help you avoid capital gains tax if itâs still only worth $250,000 at the time of the sale.
That may not be ideal, however, if it was your parentsâ wish or your desire to keep the home in the family. In that scenario, thereâs a second option you can consider.
Instead of selling the home right away, you could move into it and make it your primary residence. You could then sell the home two years later, potentially excluding some or all of the capital gains from the sale.
The IRS allows single filers to exclude up to $250,000 in capital gains from the sale of a home, increasing that to $500,000 for married couples filing a joint return. The key is that you have to live in the home for at least two of the five years preceding the sale. So if you can envision yourself living in your parentsâ home for at least two years, this is another way you might be able to avoid paying capital gains tax on the property.
A third option is to not sell the property and rent it out instead of living in it. This can be a little tricky, however, since there are still tax rules you have to observe. An inherited home thatâs treated as an investment property for tax purposes would still be subject to capital gains tax if you decide to sell it. But you could defer paying those taxes if you complete a 1031 exchange to purchase another investment property to replace the one youâre selling.
Disclaiming an Inheritance to Avoid Capital Gains Tax
Thereâs one more possibility for how to avoid paying capital gains tax on inherited property. Thatâs simply choosing not to inherit it at all.
This is called disclaiming an inheritance and itâs something you can choose to do if youâd prefer not to get entangled in tax issues related to someone elseâs estate. The downside, of course, is that once you formally disclaim an inheritance, you canât go back and change your mind. Whatever property you forfeited would be passed on to the next person in line to inherit.
The Bottom Line
Inheriting property can trigger capital gains tax if you choose to sell it. And there are other taxes you may need to consider, such as state inheritance taxes. If the inherited property is a residence consider living in it for a few years before selling it. Alternatively, consider renting it. Talking to an estate planning attorney or a tax professional may be helpful if you stand to inherit assets from your parents or anyone else and youâre worried about owing Uncle Sam.
Tips for Estate Planning
- Consider talking to a financial advisor about what you should be including in your own estate plan. If you donât have a financial advisor yet, finding one doesnât have to be complicated. SmartAssetâs financial advisor matching tool can help you connect with professional advisors in your local area in minutes. If youâre ready, get started now.
- Property taxes in America are collected by local governments as well as the federal government. The money collected is generally used to support community safety, schools, infrastructure and other public projects. A property tax calculator can help you better understand the average cost of property taxes in your state and county.
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