Capital Gains Taxes Really Do Apply to Inherited Property: Here’s How and How to Minimize Them

It’s sad they passed away, but they left you a house. Selling it may hit you with capital gains, but you can minimize them. What a rollercoaster.

Capital gains tax is a type of tax that is applicable to any profit made from the sale of an asset, including inherited property. When someone inherits property, they receive a tax basis, which is the fair market value of the property at the time of the original owner’s death. If the inheritor sells the property at a price higher than the tax basis, they will be subject to capital gains tax on the profit.

The stepped-up basis rule applies to inherited property, which may have appreciated in value over time. This rule means that the tax basis of the inherited property is adjusted to its fair market value at the time of inheritance. This allows the inheritor to avoid paying taxes on any gains that occurred before they inherited the property.

Considerations Before Selling Inherited Property

Tax Bracket and Taxable Income

When it comes to inherited property, the capital gains tax liability is determined by the tax bracket and taxable income of the person inheriting the property. The tax bracket changes annually and can range from 0-20%. The taxable income is the total income of the individual or couple for the year, including any profits from its sale. If the taxable income falls within a lower tax bracket, the capital gains tax liability will be lower. Conversely, if the taxable income is higher, the capital gains tax liability will be higher.

Property owners with higher profits from the sale of an inherited property may also be subject to the Net Investment Income Tax (NIIT), which is an additional 3.8% tax on top of the capital gains tax liability. This tax applies to individuals with a modified adjusted gross income of more than $200,000 or couples filing jointly with a modified adjusted gross income of more than $250,000. 

Fair Market Value of the Property

The fair market value of an inherited property is crucial in calculating capital gains taxes. Generally, capital gains taxes are imposed on the difference between the sale price of the property and its fair market value at the time it was inherited. As such, it’s essential to determine the fair market value accurately to avoid underpaying or overpaying taxes.

To determine the fair market value of an inherited property, one can obtain an appraisal from an expert appraiser or a real estate agent statement. These professionals can provide a detailed report on the property’s value based on the current market conditions, location, and other factors. The appraisal or statement can also serve as proof of the property’s value to the IRS.

It’s crucial to avoid solely relying on the tax assessment to determine the fair market value of an inherited property. Tax assessments may not reflect the actual market value of the property as they are often based on outdated data. Thus, getting an appraisal or real estate agent statement is a more reliable way to determine the fair market value accurately.

Primary Residence vs. Investment Property

When it comes to capital gains tax liability, owning a primary residence and investment property can have different implications. Capital gains taxes are taxes paid on any profit made from the sale of an asset, such as property.

If you owned a primary residence for at least two of the past five years and sell it for a profit, up to $250,000 of that profit ($500,000 if filing a joint return) may be excluded from taxable income. This exclusion is not available for investment properties.

Converting a rental property or an inherited property into your primary residence can also affect your tax liability. If you live in a rental property for at least two years, you may be eligible for a reduced capital gains tax rate of up to 15% when you sell it. If it becomes your primary residence and you sell it, your capital gains tax liability will be based on the fair market value at the time of inheritance, not the original purchase price.

However, the IRS has rules in place for changing a property’s designation from investment to primary residence. These include using the property as your primary residence for at least two of the past five years, and changing the property’s use from generating income to personal use.

Managing Capital Gains Taxes When You Inherit Rental Property

Inheriting a rental property can provide an additional source of income for you and your family. However, a rental property sale could cause a significant tax event.

Fortunately, there are strategies you can use to minimize capital gains taxes on rental property you inherit. With proper planning and guidance from a financial advisor, you may be able to keep more of the profit from the sale and use it to achieve your financial goals.

Transaction, Depreciation, Closing Costs and More Deductions for Selling a Rental

Selling a rental property can be a lucrative opportunity, but it’s important to understand the deductions that can reduce your tax liability. Here are some common deductions to keep in mind:

• Transaction costs: This includes realtor commissions, title fees, advertising fees, and other expenses directly related to selling it.
• Depreciation recapture: If you claimed depreciation on the property while you owned it, you’ll need to include the accumulated depreciation as taxable income when you sell.
• Repairs and improvements: Only certain repairs can be deducted, such as those that restore it to its original condition. Improvements, on the other hand, can be added to your cost basis and lower your taxable gain.
• Closing costs: Some closing costs can be deducted from your profit, such as prorated property taxes and prepaid mortgage interest.

Calculating the Capital Gains Tax Liability on Inherited Property

Stepped-up Basis Rule for Calculating Capital Gains Taxes

The stepped-up basis rule is a tax provision that affects the calculation of capital gains taxes on inherited property. Essentially, when an individual inherits property, the asset’s cost basis is “stepped up” to its fair market value (FMV) at the time of the previous owner’s death. This means that the new owner is considered to have acquired the property at its FMV, instead of the original cost basis.

One of the biggest advantages of the stepped-up basis rule is that it can significantly reduce the tax liability for the new property owner. By setting the cost basis at the property’s FMV at the time of inheritance, any gains or profits that occur after the owner takes possession are typically taxed at a lower rate.

To calculate the taxable capital gains on inherited property using the stepped-up basis rule, you would subtract the FMV at the time of inheritance from the final sale price to determine the overall gain. You would then subtract any allowable expenses or deductions, such as closing costs and depreciation recapture, to arrive at the taxable capital gains. From there, the owner’s tax rate and the length of time they held the property (long-term vs. short-term) would impact the final capital gains tax liability.

Personal Use Exclusion and Sale Price of Inherited Property

The personal use exclusion can significantly reduce the capital gains tax liability on inherited property if the property was used as the primary residence for at least two of the last five years. This exclusion can be applied to both the stepped-up basis and the original purchase price of the property.

For instance, if the original purchase price of the inherited property was $300,000 and the owner used it as their primary residence for at least two years before selling it for $550,000, they can subtract the exclusion amount of $250,000 from the sale price, resulting in a taxable gain of only $50,000.

It is important to note that the exclusion amount differs depending on the owner’s filing status. An individual can exclude up to $250,000 of gain from taxes, and a married couple filing a joint return can exclude up to $500,000 of gain from taxes. Any gains above these amounts will be subject to capital gains taxes.

Strategies for Minimizing the Capital Gains Tax Liability on Inherited Property

Buy Another One! Using Tax Code Section 1031 for Like-Kind Exclusions

Real estate investors can defer paying capital gains taxes on the sale of rental property by utilizing Tax Code Section 1031. With this provision, investors can sell their rental property and purchase a like-kind property within 180 days without paying taxes on the gains from the sale. However, timing is key in this process as they only have 45 days to identify potential replacement properties.

Missing the deadline or failing to follow the guidelines could result in hefty tax payments. Like-kind properties in the tax code definition are broad and can include various forms of property such as real estate, investment property, and potential replacement property.

Rental Properties and Rental Income

Rental properties generate rental income, which is taxed as ordinary income in the year it is received. However, rental property owners can reduce their taxable rental income using deductions for depreciation and other rental expenses. Depreciation deductions are based on the original purchase price of the property, and a portion of that cost can be deducted each year to offset rental income.

The rental property owners pay capital gains tax if they sell rental property for a profit. The capital gain is calculated by subtracting the cost basis (the original purchase price) and any depreciation deductions taken from the sale price. The capital gain is then taxed at either the short-term or long-term capital gains tax rate, depending on how long the property was owned by the owner.

Short-term capital gains tax rates apply to properties owned for less than one year and are taxed at the owner’s ordinary income tax rate. Long-term capital gains tax rates apply to properties owned for more than one year and have a lower tax rate based on the owner’s income. Owners can also defer paying capital gains taxes by utilizing a 1031 exchange, which allows them to exchange their rental property for a like-kind property and avoid capital gains tax liability.

Retirement Accounts and Tax-Loss Harvesting

Investing in retirement accounts such as 401(K) or individual retirement accounts (IRA) can be an effective strategy for minimizing capital gains tax liability when selling inherited property. By investing in these accounts, you can defer taxes on investment gains until withdrawals are made after retirement.

To invest in a 401(K) or IRA, you can set up an account with a financial advisor or through your employer (in the case of a 401(K)). Many employers offer matching contributions, which can provide an extra boost to your retirement savings.

To avoid ordinary income tax, you can make contributions to these accounts with pre-tax dollars, reducing your taxable income for the year. There are stipulated rules for these retirement plans, such as contribution limits and minimum distribution requirements after reaching a certain age.

Tax-loss harvesting is another strategy to consider when selling inherited property. This involves selling losing investments to offset the gains from the sale of the property and reducing your overall tax liability.

Depreciation Recapture Rules

When selling an inherited rental property, it’s important to consider the process for depreciation recapture and how it affects your capital gains tax liability. Depreciation expense is deducted from the rental income each year, lowering the taxable net income. However, when you sell the property, the Internal Revenue Service (IRS) will recapture this depreciation and tax it as ordinary income.

The tax rate for depreciation recapture is 25%, which is higher than the long-term capital gains tax rate of 0%, 15%, or 20% depending on your tax bracket and taxable income. This means that if you sell an inherited rental property and have a recaptured depreciation of $50,000, you’ll owe an additional $12,500 in taxes on top of your capital gains tax liability.

To reduce your overall tax liability, you can consider strategies such as tax-loss harvesting or purchasing a potential replacement property through a 1031 exchange. It’s important to consult with a financial advisor or tax professional to understand the specific rules and options available to you. Understanding the depreciation recapture rules can help you make informed decisions when selling an inherited rental property.

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