Tax Consequences for the Sale of an Inherited Property

You’ve inherited a relative’s home and are ready to put it up for sale. Before you finalize the deal, do you know whether you’ll owe capital gains tax or inheritance tax on the house? The IRS has special rules to determine whether the inherited property is taxable after it’s sold, and it pays to understand them before you decide to sell property you inherit.

TL;DR (Too Long; Didn't Read)

The IRS does not have an inheritance tax for inherited property, but you may be subject to capital gains taxes if you sell it for a profit.

Inheritance Tax on a House

The IRS does not have a tax for inherited property received from the estate of someone who is deceased. Instead, an estate tax must be paid from the estate before it is distributed to heirs. Filing an estate tax return and paying an estate tax is only required if the computed value of the property is above a specified limit. That limit is $11,180,000 for the estates of people who pass away in 2018. The limit was lower for previous years but at least $1 million. Due to this high limit, only a small percentage of taxpayers are required to pay a federal estate tax.

Although there is no IRS tax for heirs, a handful of states have an inheritance tax. In these states, each beneficiary of an estate is required to file an inheritance tax form and pay an individual tax. The states that currently have an inheritance tax include Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. In some cases, those who have a certain relationship with the deceased, such as a spouse or dependent child, may qualify for an inheritance tax reduction or exemption. Check with your state if you have questions about this tax.

Tax on Sale of Inherited Property

To find out if you will be taxed on the sale of property you inherited, you first must know the basis for the property, which is basically the value of the property for tax purposes. This basis will either be the fair market value of the property at the time of death or the fair market value on another date that is determined by the estate’s executor. The executor is responsible for communicating the fair market value to heirs of the property.

Once you know the basis of the property, you are better equipped to decide if you will need to pay a tax on its sale. From the sale price, deduct the basis, the cost of improvements, marketing costs and closing costs. If the result is negative, you have a capital loss. A positive result means you’ll need to pay a capital gains tax on inherited real estate. In this case, the sale should be reported on IRS Schedule D (Form 1040): Capital Gains and Losses, and Form 8949: Sales and Other Dispositions of Capital Assets.

The amount of tax you pay on capital gains depends on your income. It can range from zero to 20 percent of the gains. The IRS imposes penalties for taxpayers who report an inaccurate basis that reduces their tax liability. The basis must be consistent with the final value of the property used for federal estate taxes.

Step Up Basis IRS Rules

Typically, the basis of a home for IRS purposes is determined by how much a homeowner originally paid for it plus the money spent on home improvements. For example, if your parents paid $150,000 for a home 20 years ago and then spent another $50,000 on improvements over the years, the basis of the home would be $200,000 if they decided to sell. If you inherit the home instead and are told its current appraised value is $400,000, then that is the new stepped-up basis. Subsequently selling the home for $410,000 means you have capital gains of $10,000. This is significantly less than if your parents’ basis of $200,000 was used instead.

Selling the same house for $390,000 would mean you have capital losses of $10,000. The IRS will allow you to deduct $3,000 of this loss in a single year. The remainder of the loss would have to be carried over to future tax years for deduction. When declaring a capital loss, taxpayers who sell properties to relatives will be under greater scrutiny to make sure tax fraud doesn’t occur when a property is sold for less than its value. Selling a house to a family member for 1 dollar may sound like a good way to pass on inherited property, but the seller could end up facing a gift tax if the IRS determines this was more of a giveaway than a sale.

Deducting Improvements to an Inherited Home

An inherited home is likely to be outdated and in need of some repairs or improvements before it goes on the market. If you spend money on an inherited property prior to its sale, you can deduct it from any capital gains realized on the sale. In many cases, getting a home inspection prior to putting an inherited property on the market and making necessary repairs can significantly increase your profit from the sale.

Qualifying for IRS Home Sale Exclusion

Homeowners who sell their home receive an IRS benefit in the form of a home sales tax exclusion. This exclusion is $250,000 for single taxpayers and $500,000 for those who are married filing jointly. The exclusion amount can be deducted from the gains realized from the sale of a home if it was occupied by the taxpayer for at least two of the previous five years. If you inherit a home and live in it for the required amount of time, you may qualify for this exclusion when you sell the home.

Considerations for Estate Executors

The role of estate executor can be time consuming and emotionally challenging, especially if the executor was also related to the deceased. Bringing on a lawyer and financial expert for advice is recommended for complex estates that include real estate. It also makes sense to let a few weeks or months pass before making any decisions about the sale of estate property.

If the heirs to an estate express a desire to sell the property as soon as possible, an executor may decide to sell before awarding the property to the beneficiaries. The executor can have any necessary repairs done for the sale of the home, although improvements that increase the value of the home may need to be approved by probate court. All beneficiaries must be informed prior to the sale, but only the executor is required to sign the sale documents. Any capital gains taxes would then be paid by the estate before the proceeds of the sale are distributed. If the property is distributed to the beneficiaries and they sell it on their own, they will all need to participate in the sale and will be individually responsible for their portion of capital gains taxes.

An existing mortgage or lien is another important consideration for executors. Before an inherited home is sold or at the time of sale, previous loans or liens on the house must be paid in full. If an inherited home is underwater, meaning the debts against it are greater than its fair market value, the executor may want to discuss a short sale with the lender. Inheritors always have the right to refuse a property if it seems that the expense of selling it is greater than any potential profit.

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