How is Capital Gains Tax Calculated on Inherited Property?

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In the days following the passing of a loved one, the executor of the will and any legal representatives will divide the assets amongst the beneficiaries. These assets can range from stocks and cash to physical assets like houses, boats, cars, and even pets. If someone you cared for recently died – or if you are planning ahead for the future – you might be wondering how much you need to set aside for taxes.

How is capital gains tax calculated on an inherited property? Are there instances when you don’t have to pay taxes at all? 

Financial planning doesn’t stop with death. Here is what you need to know if you expect to inherit property or already have an inherited home in your possession.

What taxes do you pay as a beneficiary? 

There are multiple types of taxes involved with the passing of a loved one. The executor likely has to evaluate the value of the assets involved, settle any debts, and determine what needs to be taxed within the inheritance. Here are three types of taxes associated with death.

Estate Tax

This one is easy. The tax is pulled from the value of the estate and should be paid before any assets are distributed to beneficiaries. The executor will take care of paying this tax. The 2023 Estate Tax Exemption is $12.92 million for individuals and $25.84 million for married couples. So if your loved one passed away with only $11 million in assets, they won’t owe anything on this tax. 

The taxable income is only on money above the $12.92 million threshold. This means if your loved one had $13.92 million in assets, they would only pay taxes on $1 million.

Inheritance Tax 

Once the estate tax is settled, it’s time to move on to the inheritance tax. This is a tax paid by the recipient of the assets. This tax is often what worries beneficiaries because they can’t afford a large tax bill on inherited items. However, there is good news: this tax is only on the books in six states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. There is no federal inheritance tax. 

If you aren’t filing in any of these states, you shouldn’t have to worry about the inheritance. However, check state laws to make sure new taxes haven’t recently been passed in your area. Depending on where you live, inheritance taxes can range from 1% of the value to 20% of the value for items received.

Capital Gains Tax 

The final tax you need to consider is the capital gains tax, which is levied on the sale of your assets. If you inherit cash, you shouldn’t have to worry about this tax. However, it gets trickier if you inherit physical assets – like a house. 

>> AGENT ANSWERS: How to avoid capital gains tax on real estate?

You might have to pay capital gains taxes on any assets you inherit or sell, but the bill might not be as high as you think. Here’s what you need to know.  

How is capital gains tax calculated?

The first step when deciding if you can avoid capital gains tax on inherited property is to learn how to calculate your expected tax bill. You are only taxed on what you gained from the sale of a property, not on the value of the property itself. Consider this example if you are selling a house (not inherited):

• You bought the home for $200,000.
• You sold the home for $500,000. 
• The initial capital gains are $300,000.  

You can see from this example how your capital gains are much lower than the home sale. The next step is to deduct various other costs related to listing the home. For example, if you paid 6% commission to the Realtors involved when selling the house, you would deduct $30,000 because that was part of the cost involved in securing the capital gains on the home. If you spent $5,000 staging and preparing the home for sale, you could deduct that, too. Using this example, the deductions bring the capital gains down to $265,000. 

The final step is to subtract exclusions from the home sale. The IRS will deduct $250,000 from your tax bill if you are a single filer selling a primary residence or $500,000 if you file jointly with a partner or are considered the head of the household. This means if you live in the house full time, your capital gains bill would either be $15,000 or nothing at all. 

Of course, this changes when you inherit a property. While the capital gains tax calculation process remains the same, you aren’t able to claim the primary residence exemption unless you have lived in the home for at least two years. 

Capital Gains Taxes Are Applied on a Stepped-Up Basis

One of the most important things to know about your newly-inherited asset is that its value is applied on a stepped-up basis. This means the fair market value is adjusted based on its worth at the time of your relative’s death, not what the asset was worth when the love-one bought it. 

For example, the median home sale price in 1992 was $144,500. The median sale price in 2022 was $547,800. With the stepped-up basis, the IRS will set the market value at what the house is worth today, not the original purchase price according to the deed. 

This creates something of a loophole if you recently inherited the property. It’s not uncommon for people to sell homes immediately after they were inherited because then the profits on the home sale would be $0. If you bought a house that had an appraised value of $500,000 and sold it for $500,000 a month later, you didn’t make any taxable profits. 

If you decide to wait to sell the home for a year or so, the new valuation will be used to evaluate your gains. So, if you sold the house for $600,000 and its fair market value was $500,000 when you inherited it, the capital gains would be $100,000 (before you deduct selling expenses, Realtor fees, and other home sale costs).

Understanding the 1031 Exchange

You have multiple options when deciding whether you should sell an inherited property or keep it if you want to avoid capital gains tax. Some people want to hold on to a family home because of the memories that come with it. Other people have to share an asset with relatives and come to a unanimous agreement on what to do. You can also hold on to the property and use it as a source of rental income. If this is a path you are considering, learn about your 1031 Exchange options. 

The IRS calls this a Like-Kind Exchange and offers to waive any capital gains on the home sale when you reinvest the proceeds into a similar property. For example, if you sell a rental property and buy a similarly-sized property to turn into a rental home in another town, you can file a 1031 Exchange. 

For your inherited home, you might decide to rent it out for a few years and then sell it to purchase another investment property elsewhere. Keep in mind, this is not a tax-free deal but rather a tax deferment. When you eventually liquidate the assets (sell the property without buying anything else) you will owe capital gains tax on the home.

Tips to Streamline the Inheritance Process 

The best time to talk about estates, inheritance, and beneficiaries is when your loved ones are still alive. If you are currently preparing your will, it is best to be honest about your plans and wishes so your loved ones aren’t surprised by your assets and estate. However, not everyone has this luxury and they often have to figure out what to do with the assets of someone they love. Here are a few tips. 

• Work with an objective third party you can trust. A financial advisor or tax professional shouldn’t have any agenda when giving you advice. They should provide clear information about your tax liability. 
• Don’t make rash decisions. You shouldn’t feel pressured into making decisions on newly-inherited property. Give yourself time to mourn and decide what you want.
• Try to be fair. Some people have families that try to take more than their share of the will. Whenever possible, follow the wishes of the deceased as closely as possible. When the wishes are vague, divide the assets as evenly as possible. 

Additionally, ask your loved ones to organize their assets. No one wants to think about death, but it is the eventual reality for all of us. Take time to prepare your will and organize your finances when you are alive so you can help the people you leave behind. 

Talk to a Realtor About Capital Gains Taxes

If a loved one recently passed away and you are worried that you might have to pay capital gains tax on their assets, consult a Realtor. Real estate agents work with inherited estates frequently and can offer you advice based on their experiences. An expert agent can help you understand the fair market value of a home. They can also provide advice on whether you could benefit from selling it or making it a primary residence. 

To find a Realtor near you, turn to the experts at FastExpert. We pair sellers with the top agents in their area. Discover the top real estate agents near you and see if capital gains taxes could affect your assets.

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