Do You Pay Capital Gains Tax on Inherited Property?
Learn the tax rules for inherited property sales. Understand how basis is determined, gains are calculated, and sales are reported.
When individuals pass away, they may leave behind assets such as real estate, investments, or other valuables. Understanding the tax rules surrounding inherited property is important for beneficiaries. Capital gains tax, a tax on the profit from selling an asset, can apply to inherited property under certain circumstances.
Capital Gains Tax on Inherited Property
Inherited property generally receives a tax advantage known as a “stepped-up basis.” This rule means the cost basis of the inherited asset is adjusted to its fair market value (FMV) on the date of the previous owner’s death. This adjustment can substantially reduce or eliminate capital gains tax if the property is sold shortly after inheritance for its fair market value. For example, if an asset was purchased for $50,000 but was worth $200,000 on the date of death, the new basis for the inheritor becomes $200,000.
The stepped-up basis effectively erases any appreciation in the property’s value that occurred during the original owner’s lifetime for capital gains tax purposes. This distinguishes inherited property from assets received as gifts during a person’s lifetime. When an asset is gifted, the recipient takes on the donor’s original cost basis, known as a “carryover basis.”
Establishing the Basis of Inherited Property
Determining the correct cost basis for inherited property is a step before any potential sale. The method for establishing this basis is to use the fair market value of the property on the date of the previous owner’s death. This value represents what the property would sell for between a willing buyer and a willing seller.
In some situations, the estate’s executor may elect to use an “alternate valuation date,” which is six months after the date of death. This option is considered if the overall value of the gross estate and the federal estate tax liability are both reduced. If an asset is sold or distributed within that six-month period, its value on the date of sale or distribution becomes its basis under the alternate valuation election.
The method for determining fair market value varies by asset type. For inherited real estate, an appraisal by a qualified professional is the most reliable way to establish the fair market value. Property tax assessments or comparable sales in the area can provide initial estimates, but a formal appraisal offers a more precise valuation accepted for tax purposes.
For stocks and securities, the fair market value on the date of death is determined by taking the average of the highest and lowest trading prices on that day. If the date of death falls on a weekend, the average of the high and low prices from the trading days immediately preceding and following the death date is used. For mutual funds, the net asset value (NAV) on the date of death is used to establish the basis.
Maintaining accurate documentation is important for proving the established basis. This includes copies of the death certificate, any estate tax returns filed (such as IRS Form 706), and professional appraisal reports. Brokerage statements or other financial records showing values on the date of death are also important for investment assets.
Calculating Gain or Loss from Sale
Once the basis of the inherited property has been established, calculating any capital gain or loss upon sale is clear. The formula is the sale price of the asset minus its adjusted cost basis. The resulting figure represents either a capital gain (if the sale price is higher than the basis) or a capital loss (if the sale price is lower).
The cost basis can be adjusted for certain expenses incurred after inheritance but before sale. For real estate, the cost of significant capital improvements made by the inheritor, such as major renovations or additions, can be added to the basis, thereby reducing the taxable gain. However, routine maintenance and repairs do not increase the basis.
Inherited property is considered to have a long-term holding period for tax purposes, regardless of how long the decedent or the inheritor actually owned it. This means any gain from the sale of inherited property is taxed at the more favorable long-term capital gains rates, which are lower than short-term capital gains rates.
If multiple capital assets are sold, capital gains and losses are netted against each other. If there is a net capital loss for the year, individuals can deduct up to $3,000 of that loss against their ordinary income ($1,500 if married filing separately). Any remaining net capital loss can be carried forward to offset gains and ordinary income in future tax years.
Reporting the Sale for Tax Purposes
Reporting the sale of inherited property on a tax return involves forms and procedures. The transaction is reported on IRS Form 8949, Sales and Other Dispositions of Capital Assets. This form details each capital asset sale, including the property’s description, the date it was acquired, the date it was sold, the sales price, and the cost basis.
For inherited property, the acquisition date entered on Form 8949 is listed as “Inherited” or the specific date of the decedent’s death. After completing Form 8949, the totals are summarized on Schedule D, Capital Gains and Losses. Schedule D calculates the overall capital gain or loss for the year and integrates these figures into the individual’s income tax return, Form 1040.
Financial institutions or real estate closing agents involved in the sale of certain assets will issue IRS Form 1099-B (for securities) or Form 1099-S (for real estate) to report the sale proceeds to both the seller and the IRS. These forms ensure that the amounts reported on Form 8949 align with information received by tax authorities. If a significant capital gain is realized from the sale, individuals should consider making estimated tax payments throughout the year to avoid underpayment penalties.