Understanding how to manage your money is always complicated, but there's added complexity involved when you inherit assets from someone else. That's because if you inherit assets and sell them at a profit, it is possible you'll have to pay capital gains taxes on the money you make.
The good news is, it's often possible to avoid paying taxes on inherited property. This guide can help you understand how the rules work, as well as some of the steps you can take to avoid losing a good chunk of your inheritance to the IRS.
How taxes work on inherited property
You don’t always have to pay taxes on inherited property. Estate taxes or inheritance taxes apply to only a small percentage of estates, and generally only in situations where a substantial amount of money is transferred.
However, it's more likely you'll owe taxes if you happen to inherit property and then turn around and sell it at a profit. In this case, you may have to pay capital gains taxes, but only on the profit you make from the sale. And that can be a bit confusing because whether you make a profit depends on the "tax basis in the property," also known as the stepped-up basis, and not on the original purchase price.
The "basis" is either:
- The fair market value of the property on the date you inherit it
- The fair market value on an alternate valuation date if the estate executor chooses this option and files a tax return to make that clear.
If you sell an asset for more than your cost basis, you have taxable gains and will likely owe capital gains taxes. For example, if you inherit a painting and the fair market value of the painting is $100 on the day you inherit and you sell it for $200 a few months later, you'd likely have to pay capital gains on the $100 profit.
Now, in this scenario, you need to know that capital gains taxes work differently than regular income taxes. If you sell assets at a profit after owning them for less than a year, you'll typically pay short-term capital gains taxes. This means your ordinary tax rate will apply.
But if you own assets for more than a year and sell at a profit, then a special long-term capital gains tax rate usually applies. Depending on your income, this rate is between 0% and 20%, with most people paying the 15% rate.
The table below shows the long-term capital gains tax rates by income level and tax filing status for the 2022 tax year.
|Single||Married couples filing jointly||Married couples filing separately||Head of household|
|0%||$0 to $41,675||$0 to $83,350||$0 to $41,675||$0 to $55,800|
|15%||$41,676 to $459,750||$83,351 to $517,200||$41,676 to $258,600||$55,801 to $488,500|
|20%||$459,751 or more||$517,201 or more||$258,601 or more||$488,501 or more|
This table shows the long-term capital gains tax rates by income level and tax filing status for the 2023 tax year.
|Single||Married couples filing jointly||Married couples filing separately||Head of household|
|0%||$0 to $44,625||$0 to $89,250||$0 to $44,625||$0 to $59,750|
|15%||$44,626 to $492,300||$89,251 to $553,850||$44,626 to $276,900||$59,751 to $523,050|
|20%||$492,300 or more||$553,850 or more||$276,900 or more||$523,050 or more|
This means that even if you do end up paying capital gains tax on inherited property, you may be able to reduce your rate considerably by holding the assets for more than a year before selling. But often there are ways to avoid owing these taxes at all, if you know the right approach to take.
Ways to avoid paying capital gains taxes on inherited property
No one wants a big tax bill on property they inherit, but it's important to choose the best approach to trying to avoid capital gains taxes so your quest to keep your IRS bill down doesn't backfire on you.
Here are five possible approaches to minimizing capital gains tax obligations.
1. Don't take it
Just because you inherit assets doesn’t mean you have to take ownership over them. In fact, it’s your choice whether you want to become the legal owner of the assets someone has left behind.
If you don't want to become the legal owner of someone's assets, you can disclaim the inheritance.
You'll need to follow your state's laws for disclaiming property, but you always have the right to decline a legal interest in any asset someone tries to give to you. In most states, you'll need to disclaim the inheritance in writing by describing the legal interest in the property you are giving up and signing a document specifying that you won't accept the ownership interest.
2. Sell it right away
Selling an inherited asset right away is another good way to potentially avoid paying capital gains tax. Remember, in most cases, when you inherit a property, that property's fair market value at the time of the inheritance becomes your "basis."
You only owe capital gains if you sell for more than your basis. If you sell the property right after you inherit, the property likely won't go up in value much — if at all — compared with your basis. You won't have a profit to report, so there will be nothing to owe taxes on.
Say, for example, that your parents bought a house decades ago for $20,000, and the value of the home was $200,000 when you inherited it. Generally, your "basis" would become $200,000 because that was the home's fair market value when it came into your possession. If you sold the house shortly thereafter for $200,000, you would not have made a profit under current tax laws.
With no profit, there are no taxes to pay.
3. Move in
If you inherit a house, you may not want to sell it immediately, even for tax purposes. The good news is, you have another option.
You could move into the house and establish it as your primary residence so you could qualify for a capital gains tax exclusion.
If you sell your main home, or primary residence, you can typically exclude up to $250,000 in gains from the home sale as a single tax filer or $500,000 as a married joint filer. But you need to meet two specific criteria for the exemption: an ownership test and a use test.
To qualify for the capital gains tax exclusion, homeowners must:
- Own the house for at least two years prior to the sale
- Live in the house for at least two years prior to the sale
Making an inherited home your primary residence allows you to enjoy it for a while, and to allow the property value to grow, but to still potentially avoid capital gains tax on a home sale even if you sell it at a higher sales price and make a substantial profit.
4. 1031 exchange
In some cases, you may want to use your inherited property to help you invest in other assets. If that's the case, you may be able to avoid owing taxes on the property — even if you sell at a profit — as long as you use the proceeds of the sale to acquire a similar asset.
A 1031 real estate exchange is also called a like-kind exchange, and it is often used by real estate investors. For example, you could sell a small apartment building you own as a rental property at a profit and use the proceeds from the sale to buy a larger apartment building — and you'd be able to defer the taxes on the profits from the sale of the first property.
Like-kind exchanges apply only to real property, not personal or intangible property. There are specific rules that apply, including a requirement that the real estate you're buying be of the same nature or character as the real estate you are selling, though it can differ in terms of quality or grade. If you plan to do a 1031 exchange, it's often best to get accounting and legal professionals involved.
You can only do like-kind exchanges with investment properties, not personal residences, and you have a limited amount of time to buy the new property in order to qualify for the deferred taxes.
5. Consult a financial advisor
Depending on the nature and type of the property you inherit, your personal financial situation, and other factors, there may also be other ways to avoid paying capital gains taxes on inherited properties.
Because tax rules are complicated and you don't want to make a mistake when it comes to fulfilling your IRS obligations, consulting with a financial advisor is a good idea. You should think about getting professional help as soon as you know you'll inherit — or even consider asking your loved ones to meet with an estate planning expert before they die so they can transfer assets to you in the most advantageous way.
What are the tax rates for capital gains on inherited property?
Capital gains tax rates vary depending on how long you’ve had the inherited property before you sell it. If you hold it for less than one year, it will be subject to the short-term capital gains rate, which is the same as your ordinary tax rate (based on your tax bracket). If you hold it for more than one year, it’s subject to long-term capital gains, and your tax rate may be 0%, 15%, or 20% depending on your taxable income.
What is the difference between capital gains and income tax?
Income taxes are charged on income earned, including money earned from working or running a business. Capital gains taxes, on the other hand, are charged on income that comes from capital assets increasing in value and being sold. Virtually any assets you own can be considered capital assets, and you could owe capital gains taxes if you sell them at a profit.
Capital gains taxes work differently from income taxes, as you're subject to a different rate depending on how long you owned the asset prior to selling it. If you owned it for more than a year, you'll pay the long-term capital gains tax rate.
This is lower than the income tax rate for most people, and is typically between 0% and 20%. If you own an asset for less than a year before selling at a profit, you pay short-term capital gains taxes at your ordinary income tax rate.
What are the tax implications of an inherited property?
In a small number of states, inheritance taxes are assessed on heirs who inherit property. The federal government and some states also charge estate taxes when property is transferred from a deceased person to beneficiaries. Estate taxes are usually owed on large estates only, and the tax is paid by the estate — not those who inherit.
People who inherit property can end up owing capital gains taxes, but only if they sell assets at a profit. Often, it's easy to avoid owing these taxes by selling property soon after inheriting it or by taking other steps such as making an inherited home into a primary residence to qualify for capital gains tax exclusions.
If you inherit property, be sure to understand all the legal and financial obligations so you can avoid unpleasant tax consequences. Talking to a lawyer and a tax professional like an accountant can be a good idea. The best tax software can also help you to calculate your tax liability — if any — that results from an inheritance coming your way.
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