Capital gains tax is due on the sale of all real estate unless the homeowners qualify for a tax exclusion or deferral. The tax rate ranges from 15% to 20% federally and 5.2% to 12% in Massachusetts. As you can imagine, this can add up to quite a bit of money. It’s important to understand capital gains tax on inherited properties and how you may be able to avoid or reduce your tax liability.

How Capital Gains Is Calculated

It’s a common misconception that taxes are due on the sale price of a property or the money you receive in cash from the sale. Taxes actually only apply to the “gain” or profit from the sale. How this is calculated can be a bit complex. In its simplest form, you take the sale price and subtract the tax basis to determine the gain. So, if you sell a property for $400,000 and the tax basis is $250,000, then you owe tax on the $150,000 gain.

Tax Basis for Inherited Properties

The complicated part is calculating the tax basis. It starts with the purchase price, plus the cost of improvements, less depreciation and selling expenses, and various other factors. Fortunately, for inherited properties, the calculation is more straight forward.

Let’s assume you inherit a property from a relative with a tax basis of $250,000. That amount is “stepped up” to reflect the property’s value on the date of death. If the market value is $400,000, you would only pay taxes on anything you receive above and beyond that. It’s also possible that you might report a loss if it’s sold for less. The cash you receive at closing is completely separate from your taxable gain or loss.

Reducing or Deferring Capital Gains

There are a few ways that you might be able to avoid or reduce capital gains on an inherited property.

Option 1 – Sell It Right Away

Because the stepped-up tax basis of an inherited property reflects the market value on the date of death, selling it quickly (before market values increase) can avoid or reduce capital gains tax. However, it doesn’t make sense to rush a sale simply to avoid the tax. The tax is only on a portion of the gain. You still benefit from the remainder of that gain (which is more than the tax).

Option 2 – Make it a Primary Residence

A tax exemption is allowed for primary residences. If you live in the home for at least 2 of the last 5 years before selling it, you may qualify. The amount exempted is $250,000 of gain for single tax filers and $500,000 for married filers. Using this exemption can be helpful if you owned a property for a long time and there’s quite a bit of gain as a result. For instance, perhaps you inherited a property 10 years ago and market values have gone up by $300,000 since then. You could save $66,000 to $96,000 in capital gains taxes.

Option 3 – Use a 1031 Exchange

Another option is a 1031 Exchange, often referred to as a tax-deferred exchange. If you keep an inherited property as an investment/rental and later wish to sell it, you can defer taxes but rolling the gain into the purchase of a like-kind property (i.e., another investment property). Taxes would not be due until you sell that new property. Of course, it could also be deferred again by completing yet another 1031 Exchange.

Summary of Capital Gains Tax on Inherited Properties

We’ve seen cases where homeowners sell an inherited property and spend the proceeds, only to find out next year (when filing taxes) that they owe a large sum of capital gains. Don’t let this catch you by surprise and create a financial burden. Consult with an accountant or tax advisor before selling an inherited property. Also consider the above methods for reducing or deferring taxes. Knowing your options and what to expect will allow you to save money and make better decisions.

If you are concerned about tax burdens that your heirs may face, contact our team to discuss your estate plan. There are different ways to gift a home to your children, each with different benefits and tax consequences. We can help you select the right one for your family.