A home is one of the most generous gifts you can ever receive.
However, inheriting a property after a loved one's death can be an emotionally difficult process. Moving into the property may elicit sadness and grief.
On top of these feelings, you may have to face confusing and stressful financial decisions. One of which is having to deal with taxes.
In this article, we’ll discover whether you can avoid paying capital gains taxes on an inherited property in the US.
Keep on reading until the end, as we will also guide you to navigate the tax requirements associated with inherited property. Ready? Let’s get started.
But First, What is a Capital Gains Tax?
Capital Gains Tax (CGT) is a tax on any profit or gain made when you sell or dispose of capital assets in a tax year.
A capital asset is any type of property, whether or not connected with the taxpayer’s trade or business. Capital assets are more useful in the long term, while ordinary assets' primary value is in the daily operations of a company.
How a capital gain is taxed depends on the taxable income, how long the asset was owned before selling, and the filing status.
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Types of Taxes That Cover Inheritances
1. Inheritance Taxes
These are taxes that are levied on assets inherited from someone who passed away. The person who inherits the property pays the inheritance tax.
There are only six states in the US that impose state-level inheritance tax. These include Pennsylvania, New Jersey, Nebraska, Maryland, Kentucky, and Iowa. There is no federal inheritance tax in the US.
2. Estate Taxes
These are taxes on the right to transfer property at death.
The estate’s executor or trustee of a qualified grantor trust is the one required to file the applicable federal and state estate tax returns and ensure that all taxes are paid.
3. Capital Gains Taxes
These are taxes levied when one sells an asset for a gain, not when one inherits. These are paid on the appreciation of assets that an heir inherits through an estate.
The two types of federal capital gains tax are short-term and long-term.
Short-term capital gains tax applies to profits from the sale of an asset held for a year or less, while the long-term capital gains tax applies to assets held for more than a year before it is sold.
What Are Capital Gains Taxes on an Inherited Property?
GCTs are taxes you pay on the appreciation of the property you inherit. They are only levied when you sell the property for gain, not when you inherit it.
How Much is CGT on an Inherited Home?
The capital gains tax rates on an inherited property would be 0%, 15%, or 20%, depending on one’s income bracket.
The US Internal Revenue Service (IRS) considers an inherited property as a long-term capital gain (held for more than a year).
These tax rates are usually much lower than the ordinary income tax rate.
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How is Capital Gains Tax Liability Calculated on Inherited Properties?
If you inherit a property or asset, compared to cash, you don’t generally owe the government taxes until you sell those assets. The capital gains taxes are calculated using the stepped-up cost basis, not the original purchase price.
The basis is either:
The property's fair market value on the date you inherit it or
The property’s fair market value on the alternate valuation date if the estate executor opts for this choice and files a tax return to make it known. [1]
The rules are the same if you jointly own the inherited property. The tax will just be evenly split, according to the ownership stake of each heir who inherited a piece of the property.
It’s important to note that state laws are changing, so it’s important to consult a professional who’s well-versed in capital gains taxes.
Tips on How To Avoid Paying Capital Gains Tax on Inherited Property
1. Sell the Property As Soon as You Inherit It
The first option you have is to simply sell the inherited property quickly.
By selling it right away, there’s no room for the property to appreciate in value, and you avoid capital gains tax. After all, it’s likely that the amount of property would be the same at the time of sale.
This may be the right option for you if you inherit a property that needs extensive upkeep and you don’t have the time, money, and experience to complete the repairs yourself.
But if you profit from the sale, regardless of how quickly you sold it, you must pay for the short-term capital gains taxes. Thus, it’s best to weigh the reward of earning a profit against the risk of paying short-term capital gains taxes.
How to Report the Sale of Inherited Property On a Tax Return
- Calculate your capital gain or loss by subtracting the stepped-up tax basis from the purchase price.
- Report the sale through a form called IRS Schedule D. It documents capital gains and losses.
- Copy that information over to your Form 1040. You won’t be able to use the 1040A or 1040EZ in the year that you sold your inherited property. In 1040A, the income and adjusted gross income sections are shorter, while the 1040EZ is a simplified form of the full 1040.
- Attach the IRS Schedule D form to your tax return upon submitting it to the IRS.
If the property is split with others, meaning you’re not the sole heir, then each inheritor can claim their portion only on their tax return.
2. Take Ownership
If you don’t want to sell the property because it has a sentimental reason, then this option is the best for you.
Before worrying about selling it or the taxes you’d have to pay, ask yourself if you would truly want to say goodbye to the property, especially if it’s one you grew up in.
Moving into the property means you won’t have to pay capital gains tax because it has become your primary residence. You can claim a tax deduction even if you decide to sell it later.
To be eligible for capital gains tax exclusion, you must own the house for at least two years before the sale or live in that house for at least two years before the sale.
3. Use the Sale Proceeds to Acquire a Similar Asset
Another way to avoid paying capital gains taxes on inherited property is to use the sales proceeds to acquire a similar asset.
This is called a 1031 real estate exchange or a like-kind exchange, often used by real estate investors. Under this law, you can defer capital gains taxes on an inherited property. [2]
If you opt for a 1031 exchange, getting legal and accounting professionals involved is wise. They are well-versed with tax rules and will ensure you won’t make a mistake in fulfilling your IRS obligations.
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4. Turn It Into a Rental Property
What if, rather than paying capital gains tax, you make more money from the property left for you?
Now, that makes a good choice.
You’d literally turn your inherited home into an investment property if you choose this fourth option to avoid capital gains taxes.
Not only will you earn rental income, but you’ll also build a real estate portfolio and become a real landlord who simply waits for the rent to roll in.
5. Choose Not To Inherit the Property at All
Lastly, there’s another way to avoid paying capital gains on an inherited property. That is – to disclaim an inheritance.
This is something one can choose if they’d rather not get entangled in tax issues associated with someone else’s estate. Of course, the downside is that you can’t change your mind when you formally disclaim the inheritance.
The property you forfeited will already be passed on to the next person in line to inherit. If you choose this option, follow your state laws for disclaiming property.
Usually, the process has to be done in writing by detailing the legal interest in the property you are disclaiming and that you will not accept the ownership interest.
Even if you’re liable for capital gains tax, here are ways to reduce the impact:
Minimize Capital Gains Tax: Alternatives to Inheritance
Qualify For a Partial Exclusion
Some circumstances may qualify you for capital gains tax exclusion.
For example, your main reason for selling the inherited property is because of a special circumstance, like a health issue, unforeseeable event, or change in workplace location. In that case, you may be allowed for a partial exclusion.
To be eligible for these circumstances, the taxing authority will consider how the property was inherited and your situation.
Transfer The Property To a Trust (Before Death)
An option to minimize the capital gains tax on inherited property is to transfer the property to a trust. Once the owner passes away, the trust will become the property owner.
Again, this does not avoid capital gains tax since the trust’s creator owns the assets held in the trust. But it does provide tax benefits.
Remember that the type of trust you choose will affect the tax treatment. The grantor can modify a revocable trust, but an irrevocable trust cannot feasibly be changed.
Deduct Selling Expenses
Another strategy to minimize capital gains tax is to deduct any expenses incurred during the selling process and even for home improvement.
If you opt to use this strategy, we suggest maintaining records of home improvements made since acquiring the property and the receipts for selling expenses.
If you still owe capital gains tax on inherited property, the tax rate will be based on your filing status, tax bracket, and how long you’ve held the property.
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Why Hire a Professional for Inheritance and Estate Matters
For the person considering making significant gifts or receiving an inheritance from a loved one, you will likely file taxes.
Hiring a professional for the accounting and taxing work will help prepare the necessary papers with the IRS, so you can focus more on important things.
Plus, going through the death of a loved one is not easy. Having someone do the work for you will make the process more bearable.
Some ways they can help with inheritance and estate matters include tax planning, financial planning, preparing forms and filing when one plans to gift assets, and trust administration.
At Hall Accounting Company, we recognize the importance of hiring experts in tax and accounting. This is why we offer the following services, among others:
Tax compliance and planning
Income tax return preparation
Multi-state sales tax
IRS audit representation
Assistance in the selection of accounting methods, legal organization, and financial reporting.
We also have experience in handling inherited property, and we will take care of the complicated process on your behalf.
Schedule us a call if you need to know more about our accounting offers and potential solutions.
Bottom Line
Capital gains tax on an inherited property can burden the heir substantially.
Now that you understand the nuances of capital gains tax on inherited property,
the options shared above can help you eliminate your capital gains tax liability, if not minimize it.
May this guide help you plan ahead so you won’t be surprised at tax time.
Inheriting a property is a great honor but may also come with a hefty tax liability.
Minimize the tax implications for your inheritance with the help of a qualified tax expert at Hall Accounting Company.
Footnotes:
[1] irs.gov
[2] irs.gov