This article breaks down how capital gains work when selling inherited farmland at a profit. We will also look into the practical ways to minimize or eliminate your tax liability.
So, explore the sections below for insights that empower you to maximize your inheritance by saving on taxes.
How Much Capital Gains Tax Are You Paying When Selling Inherited Land?
To figure out the amount of capital gains tax you owe when selling inherited land, you’ll need to consider two things. One is the profit you make from the sale. Your income level is the other.
Here’s how to calculate the tax in two steps:
1. Determine your profit (capital gain).
The formula is relatively simple: Sales Price – Property Cost Basis = Capital Gain
The cost basis is the property’s starting value for tax purposes, which is often adjusted for inherited property (see more details below).
2. Apply the applicable tax rate.
Since inherited property is generally treated as a long-term asset no matter how long the heir owns it, profit from its sale is taxed at a lower rate than regular income.
Specifically, your tax rate will be either 0%, 15%, or 20%, depending on your tax bracket and filing status.
When calculating your capital gain, understanding how the property’s cost basis is determined is critical because it directly affects your profit and, therefore, how much tax you’ll pay.
A lower cost basis results in a larger gain (and a higher tax bill), while a higher cost basis reduces profit and taxes.
This aspect is particularly important for inherited property because of a special tax code provision called the “stepped-up” basis rule.
This rule adjusts the farmland’s cost basis to its fair market value at the time you inherit it. So, the basis is effectively reset for your capital gains calculation.
A professional appraisal is the best way to find the market value of the inherited property.
Ordering that appraisal as close as possible to the date of the decedent’s death achieves the most accurate valuation for cost-basis purposes.
Here’s an illustration of how all this works together:
- Your parents bought farmland for an original purchase price of $100,000.
- You inherit it decades later, and a professional appraisal sets the fair market value at $600,000.
- If you proceed to sell the land for $630,000, your capital gain is calculated as $30,000, not $530,000. If the 15% rate applies, you’ll owe $4,500 in capital gains tax.
By elevating the property’s value, the stepped-up basis essentially erases its historical appreciation for tax purposes.
That shields you as an heir from capital gains taxes on the increase in value that occurred before you inherited the farmland and lessens your potential tax burden.
How to Avoid Capital Gains Tax on Inherited Land
When receiving an inheritance of farmland you plan to sell, timing that sale to take full advantage of the stepped-up basis allows you to minimize and even eliminate capital gains tax.
Remember, the general rule is that you pay tax when you sell a house you inherited for more than its stepped-up basis. That applies to any inherited real estate, including farmland.
Selling inherited farmland shortly after getting it increases the likelihood that the sales price will be close to the new cost basis.
Continuing with the previous example, if your inherited farmland was valued at $600,000 at the time of inheritance and you execute a sale within weeks, your capital gain may actually be zero or minimal.
Contrast this with waiting longer, allowing the land to appreciate substantially. With that larger gain, it’s less likely that you’ll avoid capital gains tax on inherited real estate.
Beyond selling immediately, it’s also essential to accurately report the sale of inherited property on your tax return.
That includes accounting for allowable improvements and expenses to increase the cost basis, further narrowing the margin between the basis and the sales price and reducing the gain.
If, based on adjustments, the basis exceeds the sales price, you can take a loss on inherited property. That means paying no capital gains tax.
To speed up the sale of your farmland and proactively manage capital gains implications, consider working with a company specializing in the niche area of purchasing inherited properties for cash.
These investors understand the need for urgency and offer a streamlined process that enables them to close faster than traditional deals.
That allows heirs to sell inherited property quickly and potentially realize capital gains tax savings.
These buyers also know the complexities heirs face and are experienced in selling all types of inherited properties as is, including raw unimproved and abandoned land.
To begin the process, request a cash offer from one of the best companies that buy inherited property and accelerate your sale.
IRS §121 Exclusion
Section 121 of the Internal Revenue Code provides a tax break for eligible homeowners by effectively disregarding a portion of their profit from the sale of their principal residence.
The exclusion is up to $250,000 for individual taxpayers, while married couples filing jointly can set aside up to $500,000 of their gain.
This same provision can also be applied to inherited farmland, provided the property includes a farmhouse that qualifies as a primary residence.
An important note is that, just like any other homeowner selling their main home, individuals inheriting farmland and a farmhouse must meet specific requirements to take advantage of this exclusion.
Here are the key criteria:
- Primary Residence Definition
This dwelling must be where you live most of the time and have the most significant personal ties.
- Ownership and Use Test
You must have owned and lived in the home as your primary residence for at least two of the five years leading up to the sale.
- Two-Year Exclusion Rule
If you’ve already claimed the Section 121 exclusion on a different property in the two years preceding the current sale, you can’t use it again.
While the standard Section 121 criteria apply, inherited farmland also presents a unique allocation nuance.
The exclusion covers gains solely from the farmhouse and its immediate residential land. So, you have to divide the sales price between the residential portion of the farm and the remaining acreage and buildings to accurately calculate eligible gains.
A professional appraisal of the farmhouse, including its residential acreage, is essential for this allocation. Due to the nuances of tax laws, expert tax advice can also be beneficial.
Consider the following scenario that illustrates the sales price allocation and the Section 121 capital gains exclusion.
You sell an inherited farmland with a farmhouse for $800,000. An appraisal divides the sales price as follows:
- $300,000 allocated to the farmhouse and land around it
- $500,000 allocated to the remaining farm assets
The allocated cost basis for the farmhouse was $100,000. That leaves $200,000 in gains on the sale of the house.
Assuming you’re a single taxpayer who meets the eligibility criteria, the Section 121 exclusion of up to $250,000 would eliminate the entire gain from the house.
The entire profit from the remainder of the farm would be subject to capital gains tax.
