Do You Pay Capital Gains Tax When You Inherit a House?

Inheriting a house can bring both emotional significance and financial considerations. A common question is whether capital gains tax applies. The answer depends on how the property’s value is determined for tax purposes and how long you hold it. This article explains these key elements.

The Stepped-Up Basis Rule

When considering inherited property, “basis” refers to the value used to determine any taxable gain or loss when the property is eventually sold. For property that is purchased, the basis is generally its cost, including the purchase price and certain related expenses.

For inherited property, a different rule applies: the “stepped-up basis.” This tax provision adjusts the property’s value to its fair market value (FMV) on the previous owner’s death, effectively “resetting” the cost basis.

For example, if a home was purchased for $100,000 but was worth $500,000 at the owner’s death, the new basis for the heir becomes $500,000. The stepped-up basis rule generally eliminates any capital gains that accrued during the original owner’s lifetime.

If the inherited property is sold immediately for its fair market value at the time of inheritance, there would typically be no capital gains tax because the selling price would equal the stepped-up basis. In some instances, if the executor of the estate files an estate tax return (Form 706), an alternate valuation date, which is six months after the date of death, might be elected.

Calculating Capital Gains on Sale

While the basis of an inherited house is stepped up upon inheritance, capital gains taxes can still apply if the property is sold later for more than its stepped-up value. The general formula for calculating capital gains or losses is the sale price minus the adjusted basis.

A special rule for inherited property concerns its holding period. Regardless of how long the beneficiary actually held the property, any gain or loss from its sale is always considered long-term for tax purposes. This means that even if you sell the property the day after inheriting it, any gain would be subject to long-term capital gains tax rates, which are typically lower than short-term rates.

Long-term capital gains tax rates for most individuals can be 0%, 15%, or 20%, depending on their overall taxable income. For example, in 2024, a 0% rate applies to taxable incomes up to $47,025 for single filers, while a 15% rate applies to incomes between $47,025 and $518,900 for single filers. Short-term capital gains, which normally apply to assets held for one year or less, are taxed at ordinary income tax rates, which can be considerably higher.

Consider an example: a house is inherited with a stepped-up basis of $500,000. If it is sold for $550,000, the capital gain would be $50,000 ($550,000 sale price – $500,000 adjusted basis). This $50,000 would be subject to long-term capital gains tax. If the property were sold for less than its stepped-up basis, for instance, $480,000, a capital loss of $20,000 would result. Losses from the sale of personal-use property, such as a home, are generally not tax deductible.

Factors Affecting Your Taxable Gain

Several factors can influence the final taxable gain on an inherited house. These adjustments occur after inheritance but before the sale, potentially increasing or decreasing the calculated gain.

The basis can be increased by the cost of improvements made to the property by the inheritor, such as adding a new roof or a major renovation, as these add to the property’s value. Selling expenses, including real estate commissions, legal fees, and closing costs, can also be added to the basis, thereby reducing the taxable gain. For instance, if you have a $50,000 capital gain but incur $10,000 in selling expenses, your taxable gain would be reduced to $40,000.

Conversely, the basis must be reduced by certain factors, such as depreciation if the property was rented out after inheritance. Depreciation deductions reduce the property’s basis over time, and if the property is later sold for a profit, a portion of that gain may be subject to “depreciation recapture” at ordinary income tax rates. However, the stepped-up basis at death generally eliminates any depreciation recapture for depreciation claimed by the previous owner.

A potential exclusion for capital gains applies if the inherited house becomes your primary residence. Under Internal Revenue Code Section 121, you may be able to exclude up to $250,000 of the capital gain ($500,000 for married couples filing jointly) if you meet specific ownership and use tests. To qualify, you must have owned and lived in the home as your primary residence for at least two of the five years immediately preceding the sale. The period of ownership and occupancy by the decedent can be added to the heir’s subsequent ownership and occupancy to meet this two-year test.

In addition to federal taxes, state capital gains taxes may also apply when selling an inherited property. These taxes vary by state; some states treat capital gains as ordinary income, while others have separate capital gains tax rates. It is important to consider both federal and state tax implications when planning the sale of an inherited home.