How to Avoid Capital Gains on Inherited Property

Inheriting property often raises concerns about capital gains taxes upon sale. Capital gains are the profit from selling an asset for more than its adjusted basis. For heirs, understanding these taxes is important, as inherited assets like real estate or stocks often appreciate significantly over the original owner’s lifetime.

Understanding Stepped-Up Basis for Inherited Property

The concept of “basis” is fundamental in determining capital gains, representing the value from which profit or loss is calculated for tax purposes. For most purchased assets, the basis is the cost paid for the property, plus certain improvements. When an asset is sold, the capital gain is the difference between the sale price and this adjusted basis.

A significant tax provision for inherited property is the “stepped-up basis” rule, outlined in Internal Revenue Code Section 1014. This rule allows the basis of inherited assets to be adjusted, or “stepped up,” to the fair market value (FMV) of the property on the date of the decedent’s death. This adjustment is a substantial benefit for heirs, as it effectively eliminates any capital gains tax on the appreciation that occurred before the original owner passed away. For instance, if an individual purchased stock for $10,000 decades ago and it was worth $100,000 at their death, the heir’s new basis would be $100,000, not the original $10,000.

The determination of the stepped-up basis uses the FMV on the date of the decedent’s death. In some circumstances, the executor of the estate may elect an “alternate valuation date,” which is six months after the date of death, if it results in a lower overall estate value and a lower estate tax liability. This election affects the basis of all assets in the estate, not just a select few. The chosen date’s FMV becomes the heir’s new basis for calculating future capital gains or losses when the property is sold.

Inherited property automatically receives a long-term holding period, regardless of how long the heir actually owned the asset. This provision, found in Internal Revenue Code Section 1223, means that any capital gains realized from the sale of inherited property will be taxed at the more favorable long-term capital gains rates. These rates are lower than short-term capital gains rates, which apply to assets held for one year or less.

Consider a residential property purchased for $150,000 that appreciates to $500,000 by the owner’s death. The heir receives a stepped-up basis of $500,000. If they sell the home for $510,000, only the $10,000 appreciation since the date of death is subject to capital gains tax.

Situations Where Stepped-Up Basis Does Not Apply

While the stepped-up basis rule offers considerable tax benefits, there are specific situations where it does not apply, or applies differently, potentially exposing heirs to capital gains tax. One exception involves assets classified as “Income in Respect of a Decedent” (IRD).

IRD assets are items of income that the decedent had a right to receive but had not yet received at the time of their death. These assets do not receive a stepped-up basis because they are considered income rather than capital property. Common examples of IRD include traditional IRA and 401(k) retirement accounts, annuities, deferred compensation, U.S. savings bonds, and uncollected wages or commissions. When an heir receives distributions from these accounts, the distributions are taxable as ordinary income, not capital gains.

Another scenario where a stepped-up basis is denied involves property gifted to the decedent within one year of their death and then inherited back by the original donor or their spouse. Under Internal Revenue Code Section 1014, if an individual gifts appreciated property to someone who then dies within one year, and the same individual (or their spouse) subsequently inherits that property back, the basis of the property reverts to the decedent’s basis immediately before the gift. This rule prevents individuals from temporarily transferring appreciated property to a terminally ill relative solely to receive a stepped-up basis upon re-inheritance.

A distinct treatment of basis applies in community property states, where marital assets acquired during marriage are owned equally by both spouses. In these states, upon the death of one spouse, both the decedent’s half and the surviving spouse’s half of the community property receive a full step-up in basis to the property’s fair market value at the time of death. This means that the entire community property asset benefits from the basis adjustment. In contrast, in common law states, only the decedent’s proportionate share of jointly owned property receives a step-up in basis. For instance, if a couple in a common law state jointly owned a property, only the deceased spouse’s 50% share would receive a step-up, while the surviving spouse’s 50% share would retain its original basis.

Alternative Strategies for Reducing or Eliminating Capital Gains

Even when the stepped-up basis applies, property may appreciate further after inheritance, leading to new capital gains upon sale. Several strategies can help reduce or even eliminate these subsequent capital gains. One strategy for inherited real estate is the primary residence exclusion, available under Internal Revenue Code Section 121. This exclusion allows an heir to avoid capital gains tax on a portion of the profit from selling an inherited home if they convert it into their primary residence.

To qualify for the primary residence exclusion, the heir must meet both an ownership test and a use test. They must have owned the home for at least two years and used it as their main home for at least two years during the five-year period ending on the date of sale. If these conditions are met, a single filer can exclude up to $250,000 of capital gains, and a married couple filing jointly can exclude up to $500,000.

For instance, if an heir inherits a home with a stepped-up basis of $600,000 and lives in it as their primary residence for two years, then sells it for $800,000, they would have a $200,000 capital gain. As a single filer, this entire gain would be excluded from taxation under Internal Revenue Code Section 121.

Another strategy involves charitable donations of appreciated inherited property. If an heir is charitably inclined, donating appreciated inherited assets, such as stocks or real estate, to a qualified charity can be a way to avoid capital gains entirely. When appreciated property is donated directly to a public charity, the donor does not recognize a capital gain on the appreciation. The donor may also be eligible for an itemized deduction for the fair market value of the donated property. This eliminates the capital gains tax liability while providing a philanthropic benefit.