You may owe capital gains tax when selling a property passed down to you. So, understanding the potential implications is essential to managing your tax liability.
This article explores the intricacies of capital gains on an inherited house, covering when taxation applies, how to determine the amount, and ways to pay less or no tax at all.
Let’s delve into the details.
Do You Have to Pay Taxes on Inherited Property That You Sell?
If you sell an inherited property, it is taxable — in some circumstances but not always.
Selling the house for less than its value (tax basis) would not result in any capital gains tax, as you experienced a loss. In this case, learn how you can take a capital loss on an iherited property.
However, if the sales price is higher than the property’s tax basis, you are considered to have a capital gain and may owe tax on some or all of that profit.
Although generally you have to pay taxes on the sale of a deceased parent’s home, you can legally mitigate or avoid that tax through the following two strategies discussed in more detail later in this article:
- selling the property quickly
- making it your primary residence before selling
How Much Tax Do You Pay when You Sell an Inherited House?
The amount paid in capital gains tax when selling inherited property can vary significantly from one case to another.
What you will owe is determined by three things:
- Property selling price
- Property cost basis
- Your income level
How do those determinants factor into calculating the applicable tax amount?
The capital gain you will pay taxes on is the difference between the selling price of the house and its value for tax purposes (cost basis).
Rather than using the purchase price paid by the previous owner, you can adjust the cost basis to the property’s fair market value at the time of inheritance.
This tax policy is known as the step-up basis, and it helps inheritors by potentially reducing the tax levied on profit from the sale.
Let’s take a quick look at how this works in practice.
Suppose you inherit a house valued at $450,000 at the time. Your benefactor originally bought the property for $250,000.
If you sell the house later for $550,000, your capital gain is equal to that price minus the $450,000 stepped-up cost basis.
The $100,000 difference would be subject to capital gains tax, and not the entire $300,000 appreciation amount.
How much tax would you pay? That depends on your overall income, which determines the applicable rate.
The IRS sets income thresholds for the capital gains tax rates. They classify profit from inherited property as long-term gain no matter how long you own it. So, you will pay one of three rates for this classification.
Generally speaking:
- Taxpayers with a relatively modest income benefit from a 0% capital gains tax rate.
- Most taxpayers fall into the middle category, encompassing a wide range of incomes from the moderate to the upper middle class. That tax rate is 15%.
- High-income earners (those with substantial taxable income) are subject to the top rate of 20%.
Accordingly, your tax burden on a $100,000 gain would be $15,000 or $20,000 if you do not fall into the lower income bracket.
How to Avoid Paying Capital Gains Tax on Inherited Property?
Here are details on the two strategies referenced earlier. For more information, read our article on how to avoid capital gains tax when selling inherited property.
#1 Sell It Immediately
You have an opportunity to reduce or possibly avoid capital gains tax by selling an inherited home shortly after it becomes yours or you can sell a house while in probate.
In some cases, when you don’t need a probate to sell a house, you can even sell an inherited house before probate.
When inherited property can be sold using either of these methods, you take full advantage of the property’s recent step-up in cost basis.
As the house’s inherited value is adjusted to the market value at the prior owner’s death, the price you sell it for and the stepped-up basis will likely be close or match.
This adjustment effectively eliminates any unrealized capital gains that accrued during the benefactor’s ownership.
As a result, you would only pay tax on what is often a minimal difference in appreciation. It’s sometimes even zero, meaning you wouldn’t owe any capital gains tax.
However, things can change if you wait an extended time to sell the house.
Historically, real estate prices have tended to increase over time. So, the longer you wait to sell, the greater the chance the value of inherited property will grow.
Any appreciation over that time could result in a larger capital gain and potentially higher taxes. By selling parents’ house after death immediately, you reduce that chance.
As you prepare to sell, consider reaching out to one of the best companies that buy inherited homes to request a cash offer.
These real estate professionals purchase properties quickly and in their current condition, including homes that need extensive repairs.
If you inherited a house that needs work and even inherited a hoarder house, cash buyers will streamline the purchase process when you’re selling an inherited house as is.
You can also count on these investors when you need to immediately sell a house during probate. They eliminate the time that you’d normally need to waste getting the house ready for sale.
#2 Use the Property as Your Primary Residence Before Selling
What happens when you sell a house you inherited is that you have to pay taxes on the entire profit unless you qualify for what’s known as a primary residence exclusion.
This provision (Section 121) of the U.S. Internal Revenue Code allows certain taxpayers to exclude a portion of their capital gains from taxation when selling their home.
Therefore, this approach can be highly beneficial for real estate inheritors looking to lower their tax bill.
Here is an example to illustrate the tax advantage of this exclusion:
Section 121 allows single taxpayers to exclude up to $250,000, and married taxpayers filing jointly can exclude double that ($500,000), from the profit on the sale of their home.
So, if you made a $300,000 gain and are a single individual, you would pay tax on $50,000, the amount over and above the $250,000 exclusion.
Spouses filing jointly would get even more tax relief. In this case, the amount of the exclusion is more than the profit. That results in zero tax owed.
Note that not every taxpayer who sells their primary residence is eligible for this exclusion.
Who is? The primary requirement to qualify revolves around property ownership and use.
These two criteria mandate that you must have owned and lived in the house for at least 24 of the preceding 60 months.
Those two years do not have to be consecutive. You simply need to live there for two years total during the five years ending on the date of the sale.
For instance, you could be eligible for the exclusion if you lived in the property for two years, moved out for a year, and then used it as your primary residence for another year.
For married couples, only one spouse is required to meet the ownership test, but both have to satisfy the use requirement.
Something else you need to be aware of is a waiting period. While there is no limit on how many times you use the exclusion over your lifetime, the IRS imposes a wait time between uses.
You can only claim the Section 121 exclusion once every two years.
