In this article, we give you a clear understanding of what determines how much you may owe as far as capital gains tax is concerned when selling a property you inherited.
We also share two effective strategies to minimize or even eliminate this tax obligation.
Keep reading to learn how to avoid capital gains tax on inherited real estate and keep more money in your pocket.
How Is Capital Gains Tax Calculated When Inheriting Real Estate?
Calculating the tax you owe on the proceeds from the sale of inherited real estate involves the following steps:
- Determine the cost basis of the property.
- Subtract that amount from the sales price.
- Multiply the gain by the applicable tax rate.
For tax purposes, the cost basis for real estate is generally the original purchase price of the property plus certain adjustments, such as home improvements.
However, it’s important to note that this works differently when selling an inherited house.
The U.S. tax code has a special step-up basis provision that applies to real estate inheritance. This policy allows you to bump up the cost basis of the home.
What that means is that you can match the cost basis to the property’s fair market value at the time of the prior owner’s death instead of using the original purchase price.
For example, let’s say the decedent left you a house that originally cost $150,000 when they bought it. When you inherited the property, it had appreciated in value to $350,000.
In this instance, you would enjoy the tax benefits of a $200,000 step-up in cost basis.
Continuing this example and fast-forwarding to the sale of the house for $400,000 would result in a taxable gain of $50,000 (sales price minus stepped-up cost basis).
The amount of tax you would owe varies based on your federal tax bracket. Currently, you would apply one of three tax rates: 0%, 15%, or 20%. These are the rates for long-term gains.
For real estate that you purchase, you must own it at least one year to qualify for long-term tax rates.
But an inherited property is considered as having a holding period of more than one year, regardless of how long you have actually owned it.
The income thresholds for these rates generally result in a more advantageous tax treatment than you would experience for short-term gains.
Finishing up the example, the following are the inherited house capital gains obligations for the three rates:
- None (0%)
- $7,500 (15%)
- $10,000 (20%)
2 Legal Ways to Avoid Capital Gains Tax on an Inherited House
#1 Sell The House Before It Appreciates
Whether you sell an inherited property before probate or you can’t sell a house without probate, it is the event that triggers a tax liability.
So, the timing of that sale is critical as you look at how to avoid capital gains tax on an inherited house.
Simply put, the sooner you can sell heir property, the greater the likelihood of having no tax liability or minimizing it at the very least.
Here’s why: when you inherit a house and the tax basis is adjusted to its fair market value at the decedent’s death, the stepped-up basis and the sale price will likely be close or the same.
Read this helpful resource to further understand how to determine the fair market value of an inherited property.
Any appreciation in home value during the deceased’s lifetime is already factored in and, therefore, goes untaxed when you sell. So, a quick sale could result in no capital gain to report.
If a house is in probate, it can be sold right during the probate procedure. This might be your quickest option.
Delaying the sale of the inherited house increases your exposure to changing market conditions that could raise the property’s value, leading to a higher tax liability.
While the rate of real estate appreciation varies based on numerous factors, the general trend over time tends to be positive.
So, it follows that the longer you hold onto the property, the more time it has to significantly appreciate in value. That, in turn, would generate a substantial capital gain should you eventually sell.
As you can see, selling an inherited house as quickly as possible, whether you sell a house during probate or right after it, is an effective way to take advantage of the step-up basis and positively impact your tax scenario.
All you have to do is request a cash offer from one of the best companies that buy inherited homes.
These professionals specialize in purchasing houses quickly and in their current condition, including fixer-uppers.
Selling an inherited house ‘as is’ is a breeze with these investors as they buy properties no matter the state they’re in, even if you inherited a house that needs work, or if you inherited a hoarder house.
#2 Live in the Property, Then Sell It
An IRS rule called Section 121 Exclusion allows homeowners to omit a significant portion of any profit from the sale of their primary residence from taxable income.
What happens when you sell a house you inherited by using this exclusion is that it can reduce the capital gains on an inherited house. That can lower or potentially zero out any taxes you would otherwise owe.
You need to meet two main requirements to be eligible for this tax relief.
- You must have owned the inherited house for a minimum of two of the five years leading up to the date of the sale.
- The home must have been your principal residence (you physically lived there) for at least two years of that same five-year period.
The 24 months can fall anywhere within the five years. It doesn’t have to be a continuous block of time.
You can also meet the ownership and occupancy tests during different two-year periods within those five years.
If you meet both criteria, you can exclude a certain amount of the capital gain based on your tax filing status.
The exclusion amount for single filers is up to $250,000. For married couples filing jointly, the maximum exclusion increases to $500,000.
So, if you are single and sell your deceased parents’ house for a profit of $100,000, that falls within the exclusion limit, and you generally will owe no tax on that gain.
If you file jointly with your spouse and sell your house for a $600,000 profit, the exclusion would leave only $100,000 as a taxable gain.
As you consider this option, there are some aspects to keep in mind.
- The IRS places a frequency limitation on this rule. You may not use it more than once every two years. Depending on your situation, that may impact your timing for selling.
- If you are married and file jointly, only one of you needs to satisfy the ownership criteria. However, both of you must meet the occupancy requirement to get the full exclusion.
- Also, in limited circumstances, you may qualify for a partial exclusion if you don’t fully meet the ownership and occupancy tests.
Apart from that, remember that you can also take a loss on an iherited property.
How to Avoid Paying Capital Gains Tax on Inherited Farm Land?
Real estate used for farming activity often has a high valuation. So, you may be particularly concerned about the amount of capital gains tax on an inheritance of this nature.
Fortunately, one of the advantageous rules for capital gains on residential properties—the step-up basis—also applies to inherited farm land.
Because the property’s tax basis becomes the market value when you inherit it, selling shortly afterward helps you minimize further appreciation.
And if you sell at the stepped-up value, you avoid capital gains tax altogether.
Be aware that the Section 121 Exclusion does not apply in this instance. A farm is considered business property versus a personal residence, for which the exclusion is specifically designed.
What if there is an inherited house on your farm land? The exclusion would potentially apply only to the portion that’s the primary residence, and not the entire farm.
