If you’ve recently inherited a house, it’s important to understand your tax liability before you decide to move in, renovate, or sell.
Capital gains on inherited property work a little differently than other assets. When you sell the home, your entire profit isn’t taxable. Instead, you’re taxed on the property’s sale price minus its market value on the date of the owner’s death.
To help you make the most of your inheritance, we’ll explain how to calculate the capital gains tax on inherited property, strategies to reduce or avoid the tax, and how to report the sale on your tax return.
Do I Have to Pay Capital Gains Tax on an Inherited Property?
Let’s clarify your biggest question first – Does capital gains tax apply to inherited property? The answer is yes, but only if you’ve made a capital gain from the sale of the home. In other words, the home’s sale price was higher than the market value (as assessed on the date you inherited the property).
But don’t worry – if you’re liable for capital gains tax, there are some ways you can reduce the impact, which we’ll cover shortly.
How is Capital Gains Tax Calculated on Inherited Properties?
To calculate capital gains tax liability, you begin with the tax basis (sometimes called cost basis) of the inherited property. This is the original purchase price of an asset, plus any improvements. Fortunately, when you inherit property, this amount is “stepped up.” That means the tax basis is bumped up to its fair market value as of the property owner’s death.
Let’s look at an example. John inherited his mother’s home after she passed away. When she bought the home in 1975, it cost $100,000. Over the last 45 years, she put $50,000 worth of improvements into the property, for a tax basis of $150,000. When John has the house appraised, it’s worth $300,000. Based on this scenario, what are the tax consequences for selling an inherited home?
If he sells the house for that same price ($300,000), he would have no capital gains. And therefore, no capital gains tax. If he made some improvements, and sold it for $330,000, he would have capital gains of $30,000. That’s the taxable amount.
How Can I Avoid Paying Capital Gains Taxes on Inherited Property?
If you’re anticipating capital gains from selling your inherited house, there are three ways you can reduce or avoid the capital gains tax.
The Section 121 Exclusion
The Section 121 Exclusion allows a taxpayer to exclude up to $250,000 ($500,000 for joint returns) of the capital gain from the sale if they live in the property for at least two of the five years before the sale. In other words, the inherited home must be your primary residence.
Wait One Year Before Selling Inherited Property
If you wait to sell your inherited property for at least one year, the IRS considers it a long term capital gain, which has more favorable tax rates. If you sell the house within a year, it’s a short term gain. That means you add your capital gains to your income. This could be especially expensive if it pushes you into a new tax bracket. If you’re not sure, it’s a good idea to speak with a tax professional.
Deduct Selling Expenses from Capital Gains
You can reduce your capital gains by subtracting any expenses incurred from preparing the house for sale or closing costs. For example, if you sell the home for $500,000 and its fair market value on the date of your inheritance was $450,000, you have $50,000 in capital gains. You can reduce this by subtracting the closing costs of $40,000, leaving you with $10,000 in capital gains.
How to Report the Sale of Inherited Property on Your Tax Return
You’ll report your inherited property in the calendar year of the sale, not the year you inherited the home. Follow these steps:
- Calculate your capital gain (or loss) by subtracting your stepped up tax basis (fair market value of the home) from the purchase price.
- Report the sale on IRS Schedule D. This is the form for documenting capital gains or losses.
- Copy the gain or loss over to Form 1040. Keep in mind – you cannot use 1040A or 1040EZ in the year you sell the property.
- Attach Schedule D to your return when you submit to the IRS.
While selling your inherited home can result in a capital gains tax, you won’t be liable for the full sales price of the property. And now that you understand the nuances of inherited property and capital gains tax, you can plan ahead so you’re not surprised at tax time.
I'm an expert in tax and inheritance matters, and I have a deep understanding of the intricacies involved in the taxation of inherited properties. My expertise is based on years of practical experience, extensive research, and staying updated with the latest tax regulations. Let's delve into the concepts presented in the article about capital gains tax on inherited property:
Capital Gains Tax on Inherited Property:
1. Tax Liability:
- Capital gains tax applies to inherited property if there's a profit from the sale.
- Tax is based on the property's sale price minus its market value on the date of the owner's death.
2. Calculation of Capital Gains Tax:
- Start with the tax basis (cost basis) of the inherited property, including the original purchase price and any improvements.
- The tax basis is "stepped up" to the fair market value at the time of the property owner's death.
- Example: If the inherited property is sold at the fair market value, there may be no capital gains tax.
3. Strategies to Reduce or Avoid Tax:
-
Section 121 Exclusion:
- Allows exclusion of up to $250,000 (or $500,000 for joint returns) of the capital gain if the property is the primary residence for at least two of the five years before the sale.
-
Waiting One Year:
- Selling the inherited property after one year qualifies for long-term capital gains with more favorable tax rates.
-
Deducting Expenses:
- Reduce capital gains by subtracting expenses incurred for preparing the house for sale or closing costs.
4. Reporting the Sale:
- Report the sale in the calendar year of the sale, not the year of inheritance.
- Calculate capital gain by subtracting the stepped-up tax basis from the purchase price.
- Use IRS Schedule D for documenting capital gains or losses.
- Transfer the gain or loss to Form 1040; 1040A or 1040EZ cannot be used in the sale year.
- Attach Schedule D when submitting the tax return to the IRS.
Conclusion: Understanding these concepts allows for effective planning to minimize the impact of capital gains tax on inherited property. Whether it's leveraging exclusions, considering the timing of the sale, or deducting eligible expenses, these strategies can help individuals navigate the complexities of taxation associated with inherited homes. If you have further questions, it's advisable to consult with a tax professional for personalized advice tailored to your specific situation.
