When you sell your property, any gains you realize have to be included in your taxable income. However, special rules apply to inherited property, such as a house, that may reduce or eliminate the taxable gain you're required to include on your income tax return.
Taxable Gain Basics
Whenever you sell capital assets such as a home, the taxable portion is measured by how much higher your sales proceeds are than your basis. Your sales proceeds equal the selling price minus the costs of selling the home, such as advertising or commissions for a realtor. Your basis is typically what you paid for the home -- though there's a special exception for inherited property -- plus any long-term improvements you've made, like adding on a garage.
Inherited Home Basis
When you inherit a house, you don't pay anything for it. That doesn't make your basis in the home zero, however. Instead, the Internal Revenue Code sets your basis equal to the fair market value as of the date the person you inherited the home from dies, regardless of what that person paid for it. This means there could be a substantial portion of gain that is never taxed. For example, say your dad bought the house for $60,000 long ago and it was worth $320,000 when he died. In this case, the $320,000 becomes your basis for the home.
No matter when you sell the inherited home, the gains, if any, count as long-term capital gains rather than ordinary income, which can save you substantially on your taxes. Typically, you must own the property for more than one year before you qualify for the lower rates. For example, during the 2013 tax year, if you fall in the 15 percent tax bracket, your long-term capital gains rates aren't taxed at all. If you're between the 25 percent and 35 percent brackets for your ordinary income, the rate is 15 percent. Only if you fall in the top tax bracket do you pay the 20 percent rate on long-term capital gains.
Primary Residence Exclusion
If you used the home as your primary residence after inheriting it, you might qualify to exclude up to $250,000 -- or $500,000, if you're married filing jointly -- of the gain after the step-up in basis. To qualify, you must have owned the home for two of the five years before you sell it and have used the home as your primary residence for two of the five years before you sell it. For example, if you lived in the home for a year before inheriting it, lived in it for a second year after inheriting it, and then waited a year before selling it, you meet both tests even though the two-year periods are different for each test.
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