When you inherit property, such as a house or socks, the property is usually worth more than it was when the original owner purchased it. If you were to sell, there could be huge capital gains taxes, which could cost you thousands of dollars.
What Is Capital Gain?
Capital gain is the difference between the “basis” in property — usually real estate or stocks, but also including artwork and collectibles — and its selling price. The basis is usually the purchase price of property.
If you purchased a house for $250,000 and sold it for $450,000, you would have $200,000 of “gain” ($450,000 - $250,000 = $200,000).
However, the basis can be adjusted if you spend money on capital improvements. For instance, if after buying your house you spent $50,000 updating the kitchen, the basis would now be $300,000, and the gain on its sale for $450,000 would be $150,000 ($450,000 - ($250,000 + $50,000) = $150,000).
How Much Would My Capital Gains Tax Be?
It depends, but assume 15 percent federally, unless you have either very low or very high income, plus whatever your state’s tax is (let’s assume 5 percent, for a total of about 20 percent).
Using those assumptions, the tax on $200,000 of gain would be about $40,000. (However, there are exceptions that can depend on such factors as how long you own the property, what state you live in, or whether your total income is above a certain threshold.)
Avoiding Capital Gains Tax
Fortunately, when you inherit real estate, the property’s tax basis is “stepped up,” which means the value is re-adjusted to its current market value and often reduces or entirely eliminates the capital gains tax owed by the beneficiary.
For example, Sally’s parents purchased a house years ago for $100,000 and bequeathed the property to Sally when they pass away. When Sally inherits the property, it’s now worth $200,000.
Below are a few scenarios for how much profit from the sale of the house would be subject to capital gains taxes:
- Sally Sells the Property Immediately
Sally receives a step-up from the original cost basis from $100,000 to $200,000 (the value at the time of her parent’s death). If she sells the property right away, she will not owe any capital gains taxes.
- Sally Holds the Property and Sells the Property When It Appreciates
Several years pass, and the real estate is now worth $400,000. If Sally sells now, the difference between the stepped-up basis of $200,000 and the current value of $400,000 is subject to capital gains. In this case, Sally will pay capital gains tax on $200,000.
- Sally Lives in the House and Sells When It Appreciates
If Sally lives in the house for at least two years before selling, Sally can exclude up to $250,000 ($500,000 for a married couple) of her capital gains from taxes. This is known as the personal residence exclusion.
If the property sells for $400,000, she would be able to exclude the $200,000 in appreciation (the difference between the sale value and the stepped-up basis) that would otherwise be subject to capital gains.
On the other hand, if Sally’s parents had gifted the same property to her before their deaths, as opposed to bequeathing it to gifted, the tax basis of $100,000 would not be stepped-up. This is because gifted property does not face the same taxes as inherited property.
If Sally sold the house, she would have to pay capital gains taxes on the difference between $100,000 and the price when she sold it.
(Note that if Sally’s parents had wanted Sally to have the house while they were still alive, they might have wanted to think about options other than gifting the house, as gifting it could result in estate tax consequences. For instance, they could have considered selling the house to Sally or putting it in a trust.)
- Sally Disclaims the House to Avoid Taxes
Sally chooses not to inherit the real estate and ensures that she won’t pay taxes on the property next year. The house will then go to the next beneficiary in line.
How Is the Cost Basis of a Property Determined?
The cost basis of a property you inherit is usually how much it was worth at the time you inherited it.
The best way to determine cost basis of a property you inherit is to get an appraisal of a property's fair market value.
You might also consider using the tax assessment. However, tax assessments are often low, which would mean a higher capital gain for you when you sell the property.
Another alternative might be to secure a written statement from your real estate agent. While this would not have the weight with the IRS of an official appraisal or tax assessment, it may pass muster if done in good faith.
A Note Regarding the Stepped-Up Basis
In 2021, legislation was introduced in Congress that proposes eliminating the basis "step up." This Sensible Taxation and Equity Promotion (STEP) Act could affect heirs who inherit property.
While it is not yet known whether the STEP Act will ever become law, its introduction suggests the possibility that lawmakers are looking to make significant tax law changes that could affect your estate planning in the future.
Capital Gains Taxes in a Nutshell
Take care not to underestimate the impact of capital gains tax on inherited property. The capital gains tax rate will depend on the length of time that you hold the property; long-term rates apply if you hold the property for more than one year.
With proper planning, you can avoid paying high capital gains taxes on assets you inherit. If you have inherited property or anticipate that you will in the future, the advice of an estate professional is invaluable.
Contact an estate planning attorney in your area to learn more about how capital gains taxes can affect you, including ways to lower — or altogether eliminate — your capital gains tax.