How to Avoid Capital Gains Tax on Inherited Property
Understand how inherited property is taxed for capital gains. Learn the key tax rules that often minimize or eliminate your tax liability when selling.
Capital gains tax concerns individuals selling appreciated assets. Inherited property can lead to tax liability if appreciated. However, inherited property receives tax treatment that can reduce or eliminate capital gains tax. Understanding these rules is important for selling inherited assets.
The Basis Adjustment Rule
Basis is the cost for capital gains calculation. For inherited property, the Internal Revenue Code (IRC) provides a specific rule known as the “step-up in basis.” Under this rule, IRC Section 1014 adjusts the basis of inherited property to its Fair Market Value (FMV) on the date of the decedent’s death. This means the heir receives a new cost basis.
For example, if a decedent purchased a property for $100,000, and its FMV at the time of their death was $500,000, the heir’s new basis becomes $500,000. If the heir then sells the property shortly after inheritance for $505,000, the capital gain would be $5,000. Without this rule, the heir’s gain would be $405,000 ($505,000 minus the original $100,000 basis), leading to a larger tax burden.
This rule prevents double taxation of assets. Without the step-up, an asset could be taxed as part of the decedent’s estate and again as a capital gain when the heir sells it. The step-up in basis aligns the property’s value for estate and income tax purposes, providing relief. The holding period for inherited property is automatically long-term for the heir, regardless of how long it was held. This ensures any taxable gain is subject to long-term capital gains tax rates.
Determining Property Value for Basis Adjustment
Establishing the Fair Market Value (FMV) of inherited property at death is a key step in utilizing the basis adjustment rule. FMV is the price a willing buyer and seller would agree upon. This valuation sets the new basis for the inherited asset, impacting future capital gains.
For real estate, a professional appraisal is the common FMV method. An appraiser assesses the property based on condition, location, and recent comparable sales around the date of death. A detailed appraisal report documents the stepped-up basis. For marketable securities like stocks or mutual funds, the FMV is the closing price on the date of death, or an average of high and low prices if not publicly traded. Financial institutions provide value statements.
Thorough documentation is important. This includes appraisal reports, broker statements, and estate tax returns (Form 706), substantiating the basis for IRS review. While the date of death is the primary valuation point, an “alternate valuation date” option allows the executor to value assets six months after death, or on the sale date if sold within that period. This option is chosen if the property’s value has declined, potentially reducing estate tax liability and the heir’s capital gains.
Specific Situations and Further Considerations for Inherited Property
The tax treatment of inherited property differs from gifted property. Gifted property uses the donor’s original basis, known as a “carryover basis.” If sold, the capital gain calculation uses the donor’s initial purchase price, not the gift date value. This contrasts with inherited property, where the step-up in basis often results in little to no capital gains tax.
While the step-up in basis can eliminate capital gains on appreciation prior to death, any appreciation after inheritance and establishing the new basis is subject to capital gains tax upon sale. For instance, if property valued at $500,000 at death (the new basis) is held and sold for $600,000, the $100,000 increase is a taxable capital gain. This appreciation is taxed by standard capital gains rules, with the holding period beginning on the date of death.
If an heir makes an inherited property their primary residence, they can be eligible for the primary residence exclusion under IRC Section 121, which can reduce or eliminate capital gains upon sale. This exclusion allows single filers to exclude up to $250,000 of gain and those filing jointly to exclude up to $500,000 of gain, provided they owned and used the property as their main home for at least two of the five years preceding sale. This offers additional tax relief for those who live in the property.
If inherited property was an income-producing asset (e.g., rental) and the decedent claimed depreciation, recapture may apply upon sale, even with a step-up in basis. This taxes the previously depreciated amount at ordinary income tax rates, up to 25%, before capital gains rates apply to remaining appreciation. While the step-up resets the heir’s depreciable basis, prior depreciation can trigger a tax event upon sale.