How to Avoid Paying Capital Gains Tax on Inherited Property - A Guide
In most cases, inheriting a property is akin to winning a lottery because it comes with huge financial benefits but also has complicated tax complications.
When you dispose of the house that was left to you with an appreciation in value, there might be a capital gains tax, which can reduce your inheritance. Bear in mind that long-term gains capital levy varies depending on earnings from 0% up to 20%; hence, the necessity for well-thought-out decisions.
The article deals with basics of capital gains taxes and how this affects selling inherited properties as well as ways of minimizing one’s tax obligations. These are the strategies you could use including step-up basis and timing your sale properly to ensure that your best interests are protected financially.
What is Capital Gains Tax on Inherited Property?
First, it’s vital to clarify that you won’t automatically have to pay taxes if you inherit property. The federal government doesn’t impose federal inheritance taxes, and only six states have something similar to an inheritance tax. In case you’re wondering, an inheritance tax is the tax an heir must pay based on the property’s value.
Meanwhile, capital gains tax is based on the appreciation of any asset. This is levied only when you sell the inherited property for financial gain, not when you inherit assets. You must only pay capital gains taxes if you sell an asset. You must factor in the sales and original purchase prices to establish capital gains.
Regarding capital gains tax, how long you’ve had the inherited property impacts how much taxes you’ll have to pay once you sell it. Short-term capital gains are taxed at ordinary income tax rates if the asset is held for one year or less. Long-term capital gains, for assets held for more than one year, are typically taxed at lower rates (0%, 15%, or 20%) depending on your income.
Stepped-Up Basis while Calculating Capital Gains
The IRS implements a stepped-up basis for an asset that’s inherited. For tax purposes, the asset’s base price is reset to its value the day you inherit it. If you immediately sell the asset upon inheritance, you won’t owe any taxes on the property.
The same rule applies if you jointly inherit the property. Capital gains on inherited property are evenly split based on your ownership stake.
If a property was purchased for $200,000 and is worth $500,000 at the time of inheritance, the new cost basis for the heir is $500,000. If sold immediately for $500,000, there would be no capital gains tax owed.
9 Strategies to Avoid Paying Capital Gains Tax on Inherited Property
Various ways ensure that inherited property won’t become a tax liability exist. We’ll discuss nine strategies you can explore so you won’t owe capital gains tax on inherited property.
1. Live in the Inherited Property
Living in the inherited property is one way to avoid capital gains tax liability. You can utilize the principal residence exclusion rule, which states that you must have owned and lived in the inherited property for two out of five years preceding its sale. You’re exempted from this rule if you’re disabled, forced to relocate for your health or work, or because of death.
For example, if you inherit a house and live there as your primary residence for at least two years before selling, you can exclude up to $250,000 ($500,000 for married couples) of capital gains from your taxable income.
2. Sell the Property Immediately
You don’t have to pay capital gains tax if you immediately sell the inherited property. This is advantageous if the housing market is strong and you can obtain fair market value for your inherited property. However, this might not be a good idea if the housing market is weak and you’re forced to sell the property at a lower price.
In a recession or when the housing market is affected for various reasons, you might reconsider selling the property to defer capital gains taxes. For instance, selling the property immediately after inheriting it when the market conditions are favorable can help you avoid depreciation risks and potential repair costs.
3. Defer Capital Gains with a 1031 Exchange
A 1031 Exchange is a legislative clause that permits real estate owners to defer capital gains tax liability during property sales by swapping one property for another. This means you can postpone paying capital gains tax simply by using the money to buy a similar property.
It should be highlighted that the property bought should be like-kind, which can be anything as long as it’s not one’s personal residence. Moreover, it should have the same or higher value than the property sold.
If you want to use the 1031 Exchange, familiarize yourself with the 45-day rule. You must identify the replacement property 45 days after you relinquish the inherited property. Moreover, you need an exchange facilitator because this clause doesn’t apply if you directly receive the money to sell the property.
Interestingly, there’s also a 180-day rule stipulating that you must identify and close the replacement property 180 days after you relinquish the inherited property. These rules can confuse new real estate investors because they run concurrently.
For example, if you inherit a rental property and use a 1031 Exchange to trade it for another rental property, you can defer paying capital gains taxes until you sell the new property.
4. Convert the Property to a Rental
Another effective strategy for avoiding capital gains taxes is to convert inherited real estate into a rental property. You can rent out the entire property or, if possible, several areas to multiple tenants. This is a fantastic way to generate income on the property without selling it outright.
On the other hand, renting out the property might depreciate its value because of its wear and tear from the usage of different people. Tenants can be unpredictable and may cause some damage to the place. In the end, it might be possible that you’ll have to spend more on repairs to optimize it to sell in the future.
Renting out the property can also be a leeway to use the 1031 Exchange. That’s why you should be conscious of how the property is treated while renting out. For example, renting the property for a few years before using a 1031 Exchange to trade up to a more valuable investment property can be a smart strategy.
5. Gifting the Property
Gift tax is a federal tax on property transfers or money to others who aren’t getting anything in return. The annual and lifetime gift tax limits determine how much tax you must pay based on the amount you have gifted.
The annual gift tax exclusion is $18,000 in 2024, while the lifetime limit as of 2024 is $13.5 million. You only subtract from the lifetime limit if you exceed the annual limit.
Only the donor is required to pay the gift tax, if applicable. The gift tax ranges between 18% and 40%, depending on the gift value. A recipient is only required to pay gift tax under certain agreements.
For example, if you gift the inherited property to a family member, you may not owe capital gains tax, and the recipient can benefit from your gift tax exclusions.
6. Donate the Property to Charity
You can also opt to donate the property to charity. Donating the property to a qualified charity can provide a charitable deduction and avoid capital gains tax. Many companies donate to charity because of tax benefits, including exemption from paying capital gains tax.
You don’t even have to donate the entire property. Even partial donations can help you save on taxes. The donor can claim a deduction for the property’s fair market value, avoiding capital gains tax altogether.
For instance, if you donate an inherited property worth $300,000 to a qualified charity, you can claim a $300,000 deduction on your taxes, avoiding capital gains tax entirely.
7. Disclaim the Inheritance
You can choose to disclaim the inheritance of the property. To facilitate this process, you must file a disclaimer specifying which inheritance you’re waiving. In this case, you must proclaim that you’re disclaiming the inherited property. This should be signed to be legally binding and submitted nine months after the donor’s death.
While disclaiming a property can free you of tax on inherited property, you’ll also waive the potential gains from the inherited house or property. That’s why you should not take this decision lightly. For example, disclaiming an inherited property may make sense if you are in a high tax bracket and prefer to avoid additional taxable income.
8. Invest in a Primary Residence
If the inherited property is converted into a primary residence, the owner may qualify for a capital gains tax exclusion on the sale. The owner must have stayed there for at least two years to be excluded from paying capital gains tax.
However, there are exceptions to this rule. If conditions are met, the property value must be $250,000 for individuals and $500,000 for married couples filing jointly.
For instance, if you move into the inherited property and make it your primary residence for two years, you can exclude up to $250,000 ($500,000 for married couples) of capital gains when you sell it.
9. Establish a Trust
You can also consider transferring inherited property into a trust to help manage and protect assets while avoiding capital gains tax. This can effectively help lower one’s tax implications and maximize gain.
There are various trusts to choose from, including revocable living trusts, which allow for flexibility and control over property. Meanwhile, irrevocable trusts remove assets from the taxable estate, potentially reducing capital gains tax liabilities.
For example, placing the inherited property in a revocable living trust can provide management flexibility while deferring capital gains taxes.
Special Considerations for Different Types of Inherited Property
Contrary to what some might think, inherited property isn’t limited to real estate. Here are some special considerations you should take note of:
Inherited Stocks And Bonds
The taxes you’ll pay on stocks depend on their appreciated value. You’ll have to confer with a CPA on how much taxes you’ll owe based on the stocks and bonds you receive.
For example, if you inherit stocks worth $50,000 and sell them for $70,000, you’ll owe capital gains tax on $20,000, but with a stepped-up basis, the initial value for tax purposes is the market value at the time of inheritance.
Inherited Retirement Accounts
The IRS waives any early withdrawal penalties for inherited retirement accounts. You can receive the lump sum or roll it over to another account. You’ll only have to pay taxes if it’s a 401(k) or IRA account.
For example, if you inherit a traditional IRA, you must pay income taxes on distributions but can avoid early withdrawal penalties.
Inherited Businesses
The company’s value depends on several factors if you inherit a business. You can either sell the business or continue it once inherited.
Multiple Heir Situations
You’ll have to seek legal counsel for equitable distribution while minimizing tax implications. You can also buy out other heirs to secure a more significant inheritance.
State-Specific Considerations for Capital Gains Tax on Inherited Property
The property’s location might affect how much taxes you’ll have to pay. That’s why you should confer with local tax experts to minimize the tax implications of inherited properties. To put things into perspective, 12 states and the District of Columbia have estate taxes, while six have inheritance taxes.
Avoid Paying Capital Gains Tax on Inherited Property with Professional Help
Consult a CPA or tax expert to avoid paying capital taxes and maximize the inherited home’s value. They can help you quickly avoid the tax implications of inherited property and even plan for the future. Sign up to learn more today.
FAQs
How do you inherit a house without paying capital gains tax?
You can live in the house before selling it or sell the property immediately. You can also try the 1031 Exchange, gift the property, or donate it to charity. You also rent the property rented out to make, too.
What is the inherited capital gains tax loophole?
You won’t have to pay capital gains taxes if you sell the property upon inheritance. You can also maximize loopholes by using the property as your primary residence or renting it out using the 1031 Exchange.
How is capital gains tax calculated on inherited property?
The IRS implements a stepped-up basis for calculating tax on inherited property. The tax is calculated based on the property’s value upon inheritance. Once the capital gains are determined, the amount is considered income tax.
Do I have to report the sale of inherited property to the IRS?
You should include the inherited home in your tax forms when applicable. Some forms require you to declare your assets, including properties.
How much can you inherit without paying federal taxes?
The federal estate state exception is $13.61 over one’s lifetime as of 2024. This figure changes according to the IRS’s discretion.