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How To Avoid Paying Capital Gains Tax On Inherited Property?

How To Avoid Paying Capital Gains Tax On Inherited Property?

Good ol' Uncle Sam always wants his fair cut of your cash—even when a loved one dies and generously leaves you some property. Like it or not, inheritances have tax consequences, one of them being capital gains on assets like real estate. Fortunately, there are ways and means to minimize this tax burden legally.

Six practical ways to reduce or eliminate capital gains tax on inherited property include:

  1. Sell the property immediately
  2. Use the property as your primary residence
  3. Turn it into a rental
  4. Consider a 1031 exchange
  5. Disclaim the inheritance
  6. Deduct selling expenses from capital gains

Although not all of these strategies will appeal to you; they're highly effective ways to keep more of what you inherit. In this post, we'll explore each option to help you determine which is right for you.

Capital Gains Tax

How To Avoid Tax On Inheritance

Before we get stuck into the nitty-gritty of capital gains, it's important to understand the three main types of taxes the IRS can levy on inheritances.

  • Inheritance taxes: Heirs pay these taxes based on the value of the inherited estate. The good news is that there are no federal inheritance taxes and only six states currently levy any form of inheritance tax, including Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Unless you live in or inherited the property in one of these states, you're unlikely to be affected by it.
  • Estate taxes: These taxes are levied on an estate before anyone inherits from it. However, the estate must first meet the minimum threshold before estate taxes apply. As of 2022, that amount is $12.06 million, meaning anything over that amount is subject to taxation. Not only is the threshold incredibly high, but most states don't levy an estate tax, so the vast majority of Americans won't encounter it.
  • Capital gains taxes: When an heir sells an inherited asset like real estate or an investment, capital gains tax applies. However, it's only paid on the appreciation of the asset.

Since this post specifically deals with capital gains, let's dig into this further.

Capital Gains Tax On Inheritance: What You Should Know

When you inherit an asset like a home, as opposed to cash, you don't have to pay tax until you sell the asset. When you do eventually sell, you will need to calculate and pay capital gains tax on what's known as a stepped-up cost basis.

What does this mean?

Under normal circumstances, someone who buys a property and then sells the property for a profit will need to pay capital gains on the profit.

For example, let's say an investor buys real estate for $200,000. The closing costs are $6,000, and minor renovations are $12,000, increasing the property cost basis to $218,000. If that investor later sells the property for $280,000, the government will levy capital gains tax on the $62,000 profit.

However, it works a little differently when a property is inherited.

Let's say your parents buy a home for $250,000 and that by the time you inherit, the market value is $400,000. The moment you inherit the house, the IRS views the original cost basis stepped up to the property's current market value (i.e., $400,000).

Now let's assume you hold on to the house for a while and eventually sell it for $430,000. The profit of $30,000 will be subject to capital gains tax. How much capital gains tax?

If you own the property for less than a year, short-term capital gains tax applies. You determine this rate by your ordinary income bracket as a taxpayer.

The following table outlines tax brackets for 2022.

2022 Tax Brackets
Tax Rate Single Married (Filing Separately) Married (Filing Jointly) / Qualifying Widow or Widower Head of Household
10% $0 – $10,275 $0 – $10,275 $0- $20,550 $0 – $14,650
12% $10,276 – $41,775 $10,276 – $41,775 $20,551 – $83,550 $14,651 – $55,900
22% $41,776 – $89,075 $41,776 – $89,075 $83,551 – $178,150 $55,901 – $89,050
24% $89,076 – $170,050 $89,076 – $170,050 $178,151 – $340,100 $89,051 – $170,050
32% $170,051 – $215,950 $170,051 – $215,950 $340,101 – $431,900 $170,051 – $215,950
35% $215,951 – $539,900 $215,951 – $323,925 $431,901 – $647,850 $215,951 – $539,900
37% $539,901+ $323,926+ $647,851+ $539,901+

However, if you own the property for more than one year, long-term capital gains tax rates apply. The rate is 0%, 15%, or 20% based on your income and filing status.

The table below breaks down what this looks like for 2022.

2022 Tax Rates for Long-term Capital Gains
Tax Rate Single Married (Filing Separately) Married (Filing Jointly) / Qualifying Widow or Widower Head of Household
0% $0 – $41,675 $0 – $41,675 $0 – $83,350 $0 – 55,800
15% $41,676 – $459,750 $41,676 – $258,600 $83,351 – $517,200 $55,801 – $488,500
20% $459,751+ $258,601+ $517,201+ $488,501+

In most cases, the short-term capital gains tax rate is higher than the long-term rate, which is something to keep in mind if you're planning to hold on to the property. Either way, let's get down to why you're here.

How Can I Avoid Paying Taxes On Inherited Property?

There's no denying that inheritance can be a financially and emotionally challenging topic. For this reason, you should take a moment to review all of your options carefully before making a choice. With that said, here are the six best ways to diminish your capital gains liability.

1. Sell The Property Immediately.

Since capital gains tax is calculated based on the appreciation of the property from the time you inherit to the time you sell, getting rid of the property as quickly as possible is one easy way to minimize or completely eliminate capital gains tax. For example, if the stepped-up cost basis is $300,000 and you sell for $300,000, there will be no capital gains because there is no profit. That might not be the case in a few months if the market value of your inherited real estate increases.

Although national home appreciation values fluctuate (usually 3%-5%), The Freddie Mac House Price Index reported that housing prices in the United States rose by an eye-popping 17.8% in 2021, thanks to record-low mortgage rates and robust housing demand. That's a whole lot of profit. If you're willing to foot the bill for such massive gains, giving the taxman a small portion might be worth it.

One thing to note is that you also won't pay capital gains tax if you sell at a loss. However, the sale needs to meet certain criteria to qualify for a capital loss deduction on your taxes.

tax steady increase

What requirements do you need to meet?

  • The sale must qualify as an arm's length transaction (i.e., you don't have a prior relationship with the buyer)
  • You (or siblings) must not have used the property for personal purposes
  • The property must not have been used for personal use before the sale
  • You're selling the property at a fair market value that's less than the inherited value

If the transaction meets the criteria for a capital gains loss deduction, you'll need to file Form 8949 when submitting your yearly tax return to the IRS.

2. Use The Property As Your Primary Residence.

Another way to avoid paying capital gains tax is to move into your inherited home. A Section 121 Exclusion lets you exclude up to $250,000 if filing as a single person and up to $500,000 if filing jointly from capital gains when you do sell the property.

To qualify for this exclusion, you must live in the house for at least two years of the five years leading up to the sale. In addition, you may not have excluded the gain from the sale of another primary residence during the two-year period prior to the sale of your inherited home.

3. Turn It Into A Rental.

If you want to hang on to your inherited property but don't want to live in it, you might want to consider renting it out. This will give you a nice little side income while you decide what you want to do.

Although this approach won't eliminate capital gains once you sell, it will defer taxation until you're ready to deal with it. It also opens the door to a 1031 exchange, which we'll discuss next.

4. Consider A 1031 Exchange.

A 1031 exchange allows you to do like-kind exchanges with investment properties. For example, if you turn your inherited property into a rental, you can sell it and use the proceeds to purchase another rental property as an investment. If your inherited property happens to be a small apartment block, commercial building, or similar investment property, you can opt to do the same like-kind exchange.

As long as the piece of real estate is an investment and you're using the proceeds from the sale to buy a similar asset, you may qualify for a 1031 exchange. This approach will—at the very least—defer capital gains tax on the profit.

5. Disclaim The Inheritance.

Perhaps the least appealing option for most people is to refuse to accept the inheritance in the first place, but it might be an option that's right for you. The real estate would then pass on to the next heir in line, completely nullifying any capital gains liability you would have on the property now and in the future.

To disclaim the inheritance, you'll need to sign a legal disclaimer stating that you voluntarily choose not to accept the ownership interest for tax purposes. This decision is final, though, so make sure you're certain before you take this route.

6. Deduct Selling Expenses From Capital Gains.

The IRS allows you to deduct any expenses you incur in selling your inherited property from the profit to reduce your capital gains liability.

Expenses can include but are not limited to:

  • Advertising fees
  • Appraisal fees
  • Attorney fees
  • Closing fees
  • Costs for preparing documents
  • Costs for removing a cloud on the title
  • Escrow fees
  • Mortgage satisfaction fees
  • Notary fees
  • A real estate broker's commission
  • Settlement fees
  • Title search fees
  • Transfer or stamp taxes (charged by state, county, and city governments)

For example, if you sell the property for $500,000 and the market value at the time you inherited was $400,000, you'll have $100,000 in capital gains. Now let's say you paid a 6% sales commission to a real estate broker ($30,000) and a further $18,000 in closing costs, escrow, and attorney's fees. The profit you realized from the sale would be $100,000 – ($30,000 + $18,000) = $52,000. Therefore, you'll only pay capital gains tax on $52,000.

Wrapping Up

Although you may not be able to avoid capital gains tax altogether unless you refuse to inherit, sell your inherited property at a loss, or sell for a market value price that's the same as its stepped-up cost basis, you can at least reduce or defer capital gains tax using the other methods.

If you inherited the property on your own, the decision will be easier than if you inherited with others (such as siblings), who will also want a say. Whatever the circumstances, be sure to evaluate your options thoroughly. Real estate can be an excellent windfall that helps your financial situation, but it can also make taxes tricky to navigate.