One of the most valuable assets you can inherit from a loved one is their home. It is likely that the inherited real estate will increase in value after the date of purchase. Capital gains tax will apply to any profits made when you sell that property. There are a few tactics to avoid these taxes. In this article, we share the many methods of how to minimize capital gains tax on inherited property.
What is Capital Gains Tax?
Capital gains tax is a tax on any profits made from the sale of a capital asset. Capital assets can be anything from real estate to investments such as stocks or bonds, or even a car. The tax is typically calculated based on the difference between the purchase price (or cost basis) of the asset and the sale price. Capital gains tax rates can vary depending on several factors such as the length of time the asset was held, the taxpayer’s income level, and the state in which the asset is held.
There are two types of federal capital gains tax: short-term and long-term. Short-term capital gains tax applies to the profits from the sale of an asset held for one year or less. The short-term capital gains tax rate is the same as the individual’s income tax rate (bracket). Long-term capital gains tax is applied when an asset held for more than a year is sold. The long-term capital gains tax rate is 0%, 15%, or 20% depending on the individual’s taxable income and filing status. Long-term capital gains tax rates are typically lower than short-term rates.
In addition to paying capital gains tax at the federal level, most U.S. states also have an additional tax rate between 2.90% and 13.30%. However, in Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming there is no capital gains tax at the state level.
How to Minimize Capital Gains Tax on Inherited Property
1. Sell the inherited property quickly
The Step-Up Basis
There is an adjustment called the “step-up basis,” which allows the fair market value of the property at the date of the trustor’s death to be used during the calculation of capital gains when the property is sold. If the property qualifies for the stepped-up basis and you sell the property soon after inheritance, then you will only be taxed on the difference between the fair market value of the property at the date of death and what the property was sold for. Otherwise, the capital gains tax is the difference between the initial purchase price of the property and the sales price. If that is the case, the capital gains tax owed may create significant tax consequences.
Example: Kyle’s parents bought a home in the 1970s for $100,000. When they passed away in 2023 their home is now worth $800,000. Without the step-up basis, Kyle would have to pay capital gains on the $700,000 difference between what his parents paid and its current value. With the step-up basis in place, if Kyle inherited the property in 2023 at its market value of $800,000 and sold it 6 months later for $825,000 million, Kyle would only owe capital gains tax on the $25,000 in capital gain.
With this adjustment the sooner the inherited property is sold, the lower your capital gains taxes should be.
2. Make the inherited property your primary residence
Also, you can consider making the inherited property your primary residence, you may be eligible to reduce your capital gains tax through the personal residence exclusion. Section 121 Exclusion enables taxpayers to exclude capital gain income on a personal residence of up to $250,000 for individuals and $500,000 for married couples filing jointly. To qualify for this exclusion, the taxpayer must have lived in the property for a minimum of two out of five years before the sale.
3. Rent the inherited property
If you opt to keep the inherited property but do not wish to reside in it for a minimum of two years, you can consider renting the property. If you later decide to sell the property, the proceeds from the sale can be utilized to acquire another property of the same type. This is referred to as a 1031 tax-deferred exchange, which enables you to defer capital gains taxes on the property’s sale. There are many rules related to 1031 exchanges that should be understood before taking this approach. The sale of the rental property, if you decide not to exchange it, will create a taxable event at that time.
4. Qualify for a partial exclusion
Certain circ*mstances may qualify you for the gain exclusion. If the primary reason for selling the home or property is due to a special circ*mstance, such as a change in workplace location, a health issue, or an unforeseeable event, you may meet the criteria for partial exclusion. The eligibility for these circ*mstances is dependent on the situation and how the property was inherited.
5. Disclaim the inherited property
If you do not wish to manage the tax implications that arise when inheriting and selling inherited property, you can choose to disclaim the inheritance. Transferring the asset to the next eligible person. To disclaim an inheritance, you must sign a disclaimer with your attorney, indicating your voluntary decision to decline the property. Realize you can not change your mind once you disclaim the property.
6. Deduct Selling Expenses from Capital Gains
To minimize capital gains tax on inherited property, it is also advisable to deduct any expenses incurred during the home improvement or selling process. If you plan to utilize this strategy, it is essential to maintain records of all home improvements made since acquiring the property, as well as receipts for selling expenses, including costs for preparing the home for sale.
7. Transfer the Property into a Trust before death
To minimize the capital gains tax on inherited property, an option is to have your loved one transfer the property to a trust. After your loved one passes away, the trust will become the owner of the property. However, the type of trust you choose will impact the tax treatment. A revocable trust is a taxed separate entity until your loved one passes away. In contrast, an irrevocable trust will be taxed as a separate entity.
In conclusion, capital gains tax can place a substantial burden on the profits from the sale of inherited property. This list can help you understand your options. Nonetheless, it’s crucial to seek the advice of a professional to minimize the tax implications of inheriting property. Our CPAs are familiar with the intricacies of capital gains tax and are here to help you navigate these complexities and provide expert guidance.
