How to Avoid Paying Capital Gains Tax on Inherited Property

A capital gain is an increase in the value of an asset. When you sell an asset for more than the adjusted basis (the price you originally paid for the asset plus any additional expenses on your part), any profit you make from the sale is considered a capital gain. Once the asset is sold, capital gains are considered taxable income and subject to capital gains tax.

When it comes to inherited property, you don’t have to pay capital gains tax when you receive your inheritance. Inherited property is usually only subject to capital gains taxes once you sell the assets to gain a profit. The profit you obtain from selling inherited property depends on your basis in the property (typically the property's fair market value on the decedent’s date of death or an alternate valuation date).

Let's take a deeper look at what you need to know about avoiding or reducing capital gains taxes if you have recently inherited property or expect to come into an inheritance soon.

7 strategies to avoid or reduce capital gains tax

There are a few strategies you can implement to avoid capital gains tax or reduce your overall capital gains tax liability for an inherited property, including selling the property right away or moving into the property, among others.

Immediate sale

As long as the sale price is equal to the stepped-up basis, you may be able to prevent any capital gains by immediately selling the property upon inheritance. 

Under a stepped-up basis, an asset’s market value is determined at the time of inheritance instead of when the previous owner purchased it. A stepped-up basis can significantly reduce capital gains tax as long as the inherited property is sold right away.

For example, let’s say a relative of yours purchased a house for $100,000. By the time they pass, the house has increased in value to $200,000. You inherit the house and sell it for $225,000. With a stepped-up basis, you would only have to pay capital gains taxes on the $25,000 gains. Without the stepped-up basis, you would have to pay capital gains taxes on the full $125,000 gains.

Convert to primary residence

One way to reduce capital gain taxes is to move into the inherited property. If you use the inherited property as your primary residence for at least two years, you may qualify for an exclusion of up to $250,000 (or up to $500,000 if filing jointly) on capital gain. The two years of residency do not have to be consecutive, but they must occur within five years before the date of sale. 

Renting the Property

You might also consider renting your inherited property out or using it as a vacation home for tax purposes.

If you rent your inherited property out, you will still have to pay income tax on your rental income and may not qualify for a homestead exemption, but you can also write off expenses such as property taxes, mortgage interest, and repair costs. 

If you use your inherited property as a rental property and a vacation home, you may still be able to deduct rental expenses as long as the property meets IRS qualification requirements. 

However, you may still owe capital gains tax should you choose to sell the investment property later. 

1031 exchange

A 1031 exchange (or like-kind exchange) can be used to defer capital gains taxes for business or investment properties. A 1031 exchange is when you exchange real property that you have either used for business purposes or held as an investment property for a similar business or investment property. 

When you conduct a 1031 exchange, you usually don’t have to record a gain or loss, but if you receive other property or money as part of the exchange, you do have to report a gain for that property or money. 

For instance, you can report a 1031 exchange if you used your inheritance property as an investment property, then sold it and used the proceeds to buy another investment property.

Deduct selling expenses

Any money you pay to prepare the house for sale (such as money spent on legal fees and sales commissions) may be deductible. Deducting selling expenses can help reduce your taxable income and lower your overall capital gains tax liability. 

Disclaim the property

You can also disclaim an inheritance, which is essentially refusing whatever the decedent bequeathed you and allowing the next beneficiary to inherit the property–and deal with the taxes. 

Transfer to a trust

One final way to reduce capital gains tax on inherited property is to ask the person who wants to leave you the property to transfer the property to a trust. Trusts can be complicated, but depending on the circumstances and how the trust is set up, the trust may be responsible for paying capital gains taxes.

Tax implications and other considerations

A capital gain is considered short-term if an asset is held for one year or less, and long-term if the asset is held for longer than one year. Capital gain term lengths typically begin the day after you acquired the asset and end the day after you dispose of it. 

Short-term and long-term capital gains have different tax rates based on the net capital gain and the taxpayer’s income bracket. Net capital gain is the amount of capital gain after capital losses have been deducted. 

Short-term capital gains are typically taxed as ordinary income at graduated tax rates, meaning taxpayers pay increased taxes as the taxable amount of the asset increases. Taxpayers with long-term capital gains may benefit from a reduced tax rate. 

For tax years beginning in 2023, the tax rate on most net capital gain is 15% or less. 

To calculate capital gain taxes, you will need to look at your filing status, income bracket, and the length of time you have held the capital gain, among other information.

Capital gains tax on inherited property can be complex. It’s important to consider the potential drawbacks and legal requirements that may come into play if you are disclaiming an inheritance to avoid tax issues or have inherited property with liens or mortgages. Strategic timing and tax planning can impact the amount of capital gains tax you owe when selling an inherited property. 

If you have inherited property and are unsure  how best to handle capital gains tax, a tax professional or financial advisor can help you navigate capital gains tax rules and comply with applicable laws.

How LegalZoom can help with capital gains 

Capital gains tax on inherited property can be complex. It’s important to consider the potential drawbacks and legal requirements that may come into play if you are disclaiming an inheritance to avoid tax issues or have inherited property with liens or mortgages. 

Strategic timing and tax planning can impact the amount of capital gains tax you owe when selling an inherited property. If you have inherited property and are unsure of how best to handle capital gains tax, a tax professional or financial advisor can help you navigate capital gains tax rules and comply with applicable laws. 

Consulting with a tax professional is especially beneficial for personalized advice, particularly in complex scenarios involving trusts or significant property value. LegalZoom can also assist you with various tax planning services to ensure you make informed decisions and protect your inheritance.

FAQs

What is a stepped-up basis?

A stepped-up basis is a tax rule that sets the value of an asset at the time of an inheritance instead of when the decedent initially purchased it. You may be able to avoid capital gains tax by selling the inherited property as soon as possible.

What if the inherited property has depreciated in value?

If you sell an inherited property for less than its original value, you can potentially claim a capital loss of up to $3,000 as long as you meet the IRS’s criteria, which includes not utilizing the property for personal use. 

Are there state taxes on inherited property?

Several states have estate taxes or inheritance taxes that may apply to inherited property. State inheritance and estate tax are in addition to any applicable federal estate taxes. 

What happens if I make improvements to the inherited property before selling it?

If you make improvements to an inherited property to increase its value before selling it you can add the cost of these repairs to your basis, and may reduce the amount of capital gains tax you owe. 

The cost of significant improvements, such as remodeling a kitchen or adding a new roof, can be added to the stepped-up basis to create a new adjusted basis. This means that any profit realized from the sale after accounting for these improvements could be lower, resulting in a reduced capital gain. Keep detailed records and receipts of all improvements made, as they will be necessary for accurately calculating your adjusted basis.

Keep in mind that any money you spend on repairs to maintain the property that don’t add to the property’s value can’t be included in your basis.  

For instance, the cost of painting, fixing leaky faucets, or filling drywall holes cannot be added to your basis.

The exception to this rule is if the repairs are included in a remodeling or restoration of the home. For example, the cost of repairing a broken window would not be included in your basis unless it was part of a remodeling project that involved replacing all of the windows in the property.