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Understanding Capital Gains on Inherited Property

Inheriting property is a common occurrence, but many beneficiaries are often unprepared for the financial and tax-related implications that accompany it: capital gains on inherited property.

Capital gains on inherited property can affect the proceeds from the sale of inherited property. This article aims to provide a detailed overview of how capital gains on inherited property are determined, reported, and taxed, as well as strategies to manage the potential tax burden.

Capital Gains Tax on Inherited Property: A Primer

Capital gains tax is the tax on the profit from the sale of an asset that has appreciated in value. The capital gain is the difference between the asset’s sale price and its original purchase price, known as the “basis.” Typically, when you sell a property that you’ve purchased, capital gains tax is calculated based on how much the property has appreciated since you bought it. However, the rules are different for inherited property.

The ‘Step-Up in Basis’ Rule for Inherited Property

One of the most significant benefits when inheriting property is the “step-up in basis” rule. When a person inherits property, the basis of the property is stepped up to the fair market value (FMV) as of the date of the decedent’s death, or in some cases, an alternate valuation date six months after death, if chosen by the executor of the estate.

This means if the property was purchased by the decedent many years ago at a much lower price, the beneficiary’s basis in the inherited property is not what the decedent paid, but rather the property’s value at the time of the decedent’s death. This can significantly reduce the capital gains on inherited property if the beneficiary decides to sell the property.

Calculating Capital Gains Tax on Inherited Property

To calculate the capital gains when selling inherited property, you must determine the FMV of the property at the time of the original owner’s death. This typically requires a professional appraisal. The difference between this stepped-up basis and the sale price of the property will constitute the capital gain or loss.

Example: If the FMV of the property at the time of the decedent’s death was $300,000 and you later sell the property for $350,000, the capital gain would be $50,000, which is the amount that would potentially be subject to capital gains tax.

Exclusions and Exemptions from Capital Gains

The IRS provides exclusions that can help reduce or eliminate the capital gains tax on the sale of a primary residence. If the inherited property becomes your primary residence for at least two years within a five-year period before the sale, you may qualify for an exclusion of up to $250,000 of the gain if you’re single, or $500,000 if you’re married filing jointly.

Reporting Capital Gains Tax on Inherited Property

When inherited property is sold, the capital gains must be reported on the tax return for that year. The sale is reported on Schedule D (Form 1040), and depending on the specifics, Form 8949 may be needed to list out the details of the sale. It is advisable to retain all documentation, including the appraisal and any receipts for improvements made to the property, which can increase the basis and reduce the taxable gain.

Tax Rates for Capital Gains on Inherited Property

Long-term capital gains tax rates are applicable to inherited property held for more than a year. These rates are typically lower than ordinary income tax rates and, as of the last update prior to 2023, were 0%, 15%, or 20%, depending on the taxpayer’s income level.

Planning Considerations Before Selling

Before selling inherited property, it is important to consider several factors:

1. Timing: The real estate market fluctuates, and so does the value of property. Waiting for a favorable market could significantly affect the proceeds from the sale.

2. Potential Rental Income: Depending on its location and condition, the property might generate rental income, which could be a viable alternative to selling.

3. Emotional Value: Sometimes, the sentimental value of a property is a key consideration. It’s essential to weigh emotional attachment against financial benefits.

4. Estate Planning: How does the inherited property fit into your long-term financial goals and estate planning? Sometimes holding onto the property might be more advantageous.

5. Tax and Financial Advice: Consulting with a tax professional or financial advisor can provide clarity on the implications of selling the property. They can also help with tax planning strategies, such as offsetting the gain with capital losses from other investments.

Inheriting property can offer a financial boon, but it comes with tax responsibilities that can affect the value of your inheritance. The “step-up in basis” is a powerful provision that can reduce potential capital gains tax, but understanding and navigating the specific rules is crucial. Always seek professional advice to ensure compliance with tax laws and to make strategic decisions that align with your financial goals.

Stephen "Josh" Ralph

Retired Air Force veteran Stephen, along with his wife Michelle, founded Onyx REI. Together, they help home sellers navigate the real estate market throughout Hampton Roads, Virginia.

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