How to Calculate Capital Gains on Inherited Property

When you sell an asset, the profit is generally subject to capital gains tax. This tax applies to assets like real estate, stocks, and other property. Inherited property has specific tax rules that differ from assets you purchase. These rules significantly impact the capital gains tax owed when the property is sold by the beneficiary.

Understanding Basis for Inherited Property

The “basis” of an asset is its value for tax purposes, used to calculate gain or loss upon sale. For inherited property, the basis is “stepped up” to its fair market value (FMV) on the date of the decedent’s death. This means any appreciation in value during the original owner’s lifetime is not subject to capital gains tax when the property is inherited.

Determining the fair market value at the date of death is important for establishing this stepped-up basis. This valuation is the price a willing buyer and seller would agree upon. Appraisals by qualified professionals are commonly used to establish the FMV, especially for real estate, and comparable sales can provide supporting evidence. If an estate tax return (Form 706) was filed, the value listed on that return is used as the basis.

In some situations, an executor might elect an alternate valuation date (AVD), which is six months after the decedent’s death. This option is available only if it reduces both the gross estate’s value and the estate tax liability. If property is sold or distributed within that six-month period, its value on the date of sale or distribution is used as the AVD. The election to use the AVD applies to all assets in the estate.

Inherited property has a specific holding period for capital gains purposes. Regardless of how long the decedent owned the property or how long the beneficiary holds it before selling, inherited property is automatically considered long-term. This means any gain from the sale will be treated as a long-term capital gain, which benefits from lower tax rates than short-term gains. Documentation like the death certificate, estate tax returns (Form 706), and appraisal reports are important to establish the correct basis.

Calculating Gain or Loss

Once the basis of the inherited property is established, calculating the capital gain or loss is simple. The formula is: Selling Price – Adjusted Basis – Selling Expenses = Capital Gain or Loss. This calculation determines the taxable profit or deductible loss from the sale.

The “selling price” refers to the total proceeds received from the sale of the property, before any deductions for expenses. The “adjusted basis” is the stepped-up basis determined at the date of the decedent’s death or the alternate valuation date. It represents your investment in the property for tax purposes.

Selling expenses can reduce the capital gain. These expenses are costs directly related to the sale of the property. Common selling expenses include real estate commissions, legal fees, appraisal fees, title insurance, and transfer taxes. For example, if you sell inherited property for $400,000 with a stepped-up basis of $350,000, resulting in a $50,000 gain, but incur $10,000 in selling expenses, your taxable gain would be reduced to $40,000.

Consider a property inherited with a stepped-up basis of $300,000. If it sells for $320,000 and selling expenses amount to $15,000, the capital gain would be $5,000 ($320,000 – $300,000 – $15,000). Conversely, if the property sold for $290,000 with the same basis and expenses, there would be a capital loss of $25,000 ($290,000 – $300,000 – $15,000).

Reporting the Sale

Reporting the sale of inherited property and the resulting capital gain or loss on your federal income tax return involves specific forms. The primary IRS forms used are Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses. These forms detail your capital asset transactions and summarize your overall capital gains or losses for the tax year.

On Form 8949, you list the details of the sale, including a description of the property, the date it was sold, and the sales price. For the “date acquired” column, you enter “Inherited” rather than a specific date, reflecting the automatic long-term holding period. You also enter the adjusted basis, which is the stepped-up fair market value as of the date of death or alternate valuation date.

The totals from Form 8949 are carried over to Schedule D. Schedule D is where your net capital gain or loss is calculated. The net capital gain or loss from Schedule D is transferred to your main income tax form, such as Form 1040.

Long-term capital gains are subject to preferential tax rates, which are lower than ordinary income tax rates. For most taxpayers, these rates are 0%, 15%, or 20%, depending on their overall taxable income. This tiered structure means lower-income taxpayers may pay no capital gains tax on inherited property, while higher-income individuals will pay either 15% or 20% on their gains.