How To Avoid Paying Capital Gains Tax on Inherited Property

Article Summary:

Capital gains tax applies if you inherit a property that appreciates in value. However, the IRS excludes the gains from before the inheritance through their stepped-up basis program, which measures fair market value when you inherit a property. There are also several other solutions, such as a 1031 exchange, that allow you to mitigate or avoid capital gains tax liability on an inherited property.

The death of a close family member is an incredibly difficult time for any person. Grieving is hard enough on its own, but funeral arrangements and dealing with the deceased’s last will and testament can be an incredibly taxing endeavor.

Often, a family member will inherit property from their loved one’s estate. In such a situation, you may think to yourself, “This house was bought by my grandmother in 1973 and has definitely appreciated in value. Do I have to pay tax on that appreciation when I inherit the house, and are there tax consequences for that?” The answer to these questions is both yes and no.

How do taxes work for inherited property?

The capital gains tax you need to pay on an inherited property depends on when you sell the property. If you inherit a house and sell it right away, you probably aren’t going to pay any capital gains tax.

This is because of the IRS’s “stepped-up basis program.” The IRS will assess the property’s fair market value at the time you inherit it, and they define the gains as the difference in this fair market value between the time you inherit it and when you sell it.

Aside from this tax loophole, there are other strategies you can use to substantially mitigate capital gains tax should you ever decide to sell your inherited property.

Need a tax professional to assist you when filing taxes after inheriting property? Here are some of the top professionals in the business who can help you.

Types of capital gains

Capital gains are gains made on the sale of an asset that has grown in value. This could be a stock, a bond, a company, a rare trading card, a property, etc. As long as the asset’s value when you sell it is greater than the original purchase price and cost basis, you are responsible for paying taxes on those capital gains.

There are two types of capital gains: short-term capital gains and long-term capital gains.

Short-term capital gains

In the United States, assets sold for a gain within a year of purchase are taxed as ordinary income. Here are the 2022 ordinary income tax brackets for single filers in the U.S.:

Taxable income bracketTax owed
$0 to $9,95010% of taxable income
$9,951 to $40,525$995 plus 12% of the amount over $9,950
$40,526 to $86,375$4,664 plus 22% of the amount over $40,525
$86,376 to $164,925$14,751 plus 24% of the amount over $86,375
$164,926 to $209,425$33,603 plus 32% of the amount over $164,925
$209,426 to $523,600$47,843 plus 35% of the amount over $209,425
$523,601 or more$157,804.25 plus 37% of the amount over $523,600

Long-term capital gains

Any asset sold after a year will be taxed as long-term capital gains. Your rate of capital gains tax will depend on your income tax bracket: basically, the lower your income, the less you’ll have to pay in capital gains taxes. Here are the tax rates for long-term capital gains as of 2022:

Stepped-up basis

To avoid capital gains tax on inherited property, it’s important you first understand the IRS’s stepped-up basis program. The IRS knows that in many cases, an inherited property was held by the original owner for a long time before their death. Expecting the inheritor to shoulder all of that capital gains tax liability is a lot to ask, especially if they already paid estate tax on the estate before inheriting it.

So instead, the IRS assesses the value of the property at the time of inheritance, and the gains made between the time the property was bought and the time it was inherited are essentially wiped clean. This means that if you sell the property right away without further gains, you’ll receive a capital gains tax exclusion (i.e., you’ll pay zero capital gains tax).

Here are some scenarios to illustrate how you can use the stepped-up basis program to avoid or mitigate capital gains tax on inherited property.

How to avoid paying capital gains tax on inherited property

Imagine, if you will, a medical device salesman named Camilo who makes $80,000 a year. Camilo lives in Denver, Colorado, but he just inherited a house from his recently deceased grandmother in the (more expensive) town of Boulder, just a short drive away. Here are the facts about the house:

  • Original purchase price in 1980: $100,000
  • Fair market value: $1,000,000
  • IRS’s stepped-up assessed value: $1,000,000

Now Camilo faces a conundrum: he eventually wants to sell the property, but he doesn’t know when would be the best time to do so. Let’s go over three scenarios for Camilo to sell the house and see which case would help him avoid the most capital gains taxes.

Scenario #1: Sell right away

If Camilo sells the house immediately after inheriting it, then the property likely won’t have time to appreciate. This means there will be no change in the fair market value of the property, so he won’t pay any capital gains tax on it.

$1,000,000 (sales price) – $1,000,000 (fair market value) = 0 (capital gains)

Scenario #2: Sell in six months

In this scenario, Camilo believes the market is hot and decides to hold the property for a while. As it turns out, his intuition was correct: in six months, the property appreciates to a value of $1,200,000. However, because he’s had the house for less than a year, selling it now means he will be taxed on the capital gains as if they were ordinary income. Camilo will need to pay the difference between the selling price of the property and its assessed fair market value.

$1,200,000 (sales price) – $1,000,000 (fair market value)  = $200,000 (capital gains)

$200,000 * 22% (Camilo’s ordinary income tax rate) = $44,000 (capital gains tax)

Scenario #3: Sell in three years

In this case, Camilo decides to wait three years before selling the house. In that time, the property has appreciated to $1,500,000. Now it’s considered a long-term capital gain, so he will be taxed according to long-term capital gains tax rates, which are also based on his income level.

$1,500,000 (sales price) – $1,000,000 (fair market value at inheritance)  = $500,000 (capital gains)

$500,000 * 15% (Camilo’s long-term capital gains tax rate) = $75,000 (capital gains tax)

Basically, the best time for Camilo to sell the house depends on the short-term and long-term trajectory of the market, as well as his individual need for cash. He can avoid taxes if he sells right away, but if the market is hot, he stands to make more money even after paying capital gains tax.

Pro Tip

It’s always a good idea to get help with your taxes from a tax professional, especially if your situation is unique. If you think you might owe capital gains taxes, a tax pro can tell you the best way to handle them.

Other ways to avoid paying capital gains tax

The stepped-up basis is the cornerstone of mitigating capital gains tax on inherited property, but there are a few other strategies you can use as well.

Live in the home as a primary residence

Continuing from the previous example, if Camilo doesn’t have a home of his own or needs to upgrade his current living situation, then he can claim the inherited house as his primary residence. Then when he finally sells it, he’ll be able to mitigate or avoid capital gains taxes on it.

According to the IRS, if you sell a primary residence, you are exempt from taxes on up to $250,000 of the capital gains on the sale. However, it’s important to note that you need to live on a property for at least two of the five years before selling it to claim it as your primary residence.

1031 exchange

The 1031 exchange program allows property owners to avoid capital gains tax if they buy another “like-kind” property. Camilo could hold on to the house and rent it out, then eventually sell it with no capital gains, so long as he enters into a contract on another property within 45 days.

This strategy would only make sense for Camilo if he holds the property long enough to realize capital gains above the stepped-up assessment of the house’s fair market value and selling price.

Reverse mortgages and inheriting property

Reverse mortgages are a popular way for elderly homeowners to receive income. With a reverse mortgage — also known as a home equity conversion mortgage (HECM) — the homeowner relinquishes the equity in their home in exchange for monthly payments.

According to the Consumer Financial Protection Bureau,

“With a reverse mortgage loan, the amount the homeowner owes to the lender goes up—not down—over time. This is because interest and fees are added to the loan balance each month. As your loan balance increases, your home equity decreases.”

Because this option is particularly popular among elderly homeowners, it’s important to check if the property you are inheriting comes with a reverse mortgage. If, for example, the property comes with $50,000 of reverse mortgage debt, you wouldn’t inherit it free and clear. That debt must be paid before you can own the title.

If an inheritor is unable to pay the debt on a reverse mortgage, then the bank, which typically has a first lien, may foreclose on the property. Therefore, if you inherit property, make sure you are aware of any reverse mortgages or further liens on the home.

FAQ

Do I pay capital gains tax on a house I inherited?

It depends. You’ll likely have no tax liability if you sell the home right away, assuming there is no gain between the selling price and the IRS’s assessment of fair market value at the time of inheritance. If you hold the property, you will be liable for any capital gains realized when you eventually sell.

How can I avoid paying taxes on inherited property?

You can sell the property right away, use it as a primary residence, or exchange it for another investment property through a 1031 exchange.

Do heirs pay capital gains tax on property?

Only if there is a difference between the IRS’s fair market value assessment upon inheritance and the eventual selling price.

How do you calculate capital gains on an inherited property?

Capital gains on inherited property are calculated as the difference between the property’s fair market value at the time of inheritance, as assessed by the IRS, and the price of the property when sold. You would then pay capital gains tax on this difference based on whether it’s a short-term capital gain or a long-term capital gain.

What are the tax rates for capital gains on inherited property?

Zero if you sell right away, or a long-term or short-term tax rate based on your income level.

What are the tax implications of inherited property?

You may have to pay capital gains taxes if you hold on to the property and then sell it for more than it was worth at the time of inheritance. Furthermore, you might have to pay an estate tax on a large estate before you inherit it. And watch out for reverse mortgage debt; although it’s not a tax, it’s still a financial liability!

Key Takeaways

  • Capital gains tax is due on the profit from the sale of an inherited property, but only if the property is not sold right away.
  • The IRS assesses inherited property through their stepped-up tax basis program, which determines the property’s fair market value upon inheritance.
  • Any positive difference between the sales price of an inherited home and its assessed fair market value will be liable for capital gains tax.
  • The calculated capital gains tax liability depends on whether the gain qualifies as a short-term capital gain or a long-term capital gain.
  • It’s important to make sure your inherited property does not come with a reverse mortgage or other debt when you inherit it.
View Article Sources
  1. Gifts & Inheritances – IRS.gov
  2. Topic No. 409 Capital Gains and Losses – IRS. gov
  3. Topic No. 701 Sale of Your Home – IRS.gov
  4. What is a reverse mortgage? – Consumer Financial Protection Bureau
  5. If I have a reverse mortgage loan, will my children or heirs be able to keep my home after I die? – Consumer Financial Protection Bureau