Inheriting a home or other property can increase the value of your estate but it can also result in tax consequences. If the property you inherit has appreciated in value since the original owner purchased it, you could be on the hook for capital gains tax should you choose to sell it. That could result in a large tax bill if there’s a sizable gap between the original purchase price and the price you’re able to sell the property for. There are some possibilities for how to avoid paying capital gains tax on inherited property which are worth considering if you’re the beneficiary of an estate or trust. A financial advisor could also help you create a tax strategy for your estate needs and goals.
Understanding the Capital Gains Tax
Capital gains tax applies when an investment is sold for more than its original purchase price. Typically, you might think about capital gains tax in terms of selling stocks or other securities you hold inside your investment portfolio. So if you bought a stock for $2 per share and sold it for $5 per share, you’d owe capital gains on the $3 in profit you realized from the sale.
The IRS taxes capital gains differently, depending on how long you hold the underlying asset. The short-term capital gains tax rate applies to investments or assets you hold for less than one year. The long-term capital gains tax rate applies to investments or assets you hold longer than one year.
Capital gains tax generally applies when you sell an investment or asset for more than what you paid for it. The short-term capital gains tax rate is whatever your normal income tax rate is and it applies to investments you hold for less than one year.
For 2021, the maximum you could pay for short-term capital gains is 37%. For reference, the table below breaks down 2021 short term capital gains tax rates by filing status:
|Federal Short-Term Capital Gains Tax Rates for 2021|
|Rate||Single Filers||Married Couples Filing Jointly||Head of Household|
|10%||Up to $9,950||Up to $19,900||Up to $14,200|
|12%||$9,951 to $40,525||$19,901 to $81,050||$14,201 to $54,200|
|22%||$40,526 to $86,375||$81,051 to $172,750||$54,201 to $86,350|
|24%||$86,376 to $164,925||$172,751 to $329,850||$86,351 to $164,900|
|32%||$164,926 to $209,425||$329,851 to $418,850||$164,901 to $209,400|
|35%||$209,426 to $523,600||$418,851 to $628,300||$209,401 to $523,600|
|37%||$523,601 or more||$628,301 or more||$523,601 or more|
Between the two, the long-term capital gains tax rate is more favorable. While short-term capital gains are taxed at your ordinary income tax rate, long-term capital gains are taxed at 0%, 15% or 20% tax rates, based on your filing status and taxable income for the year.
For a comparison, this table breaks down 2021 long-term capital gains tax rates by filing status:
|Federal Long-Term Capital Gains Tax Rates for 2021|
|Rate||Single||Married Filing Jointly||Married Filing Separately||Head of Household|
|0%||$0 – $40,400||$0 – $80,800||$0 – $40,400||$0 – $54,100|
|15%||$40,401 – $445,850||$80,801 – $501,600||$40,401 – $250,800||$54,101 – $473,750|
As you can see, tax payers with capital gains over $445,851 could benefit from lower long-term rates (20%) when compared with top the short-term tax rate (37%). So if you’re in a higher tax bracket, it typically makes more sense to hold investments longer to minimize the amount of capital gains tax you owe. Note that some states may also charge their own capital gains taxes.
Note, however, that the top capital gains tax rate may raise in the near future due to changes on Capitol Hill.
Capital Gains Tax Rules for Inherited Property
When inheriting property, such as a home or other real estate, the capital gains tax kicks in if you sell that asset at a higher price point than the person you inherited it from paid for it. Likewise, it’s possible to claim a capital loss deduction if you end up selling the property at a loss.
The difference with inherited property, however, is that the IRS allows you to use what’s known as a stepped-up basis for calculating capital gains tax liability. The step-up cost basis represents the value of the home when you inherit it versus its original purchase price.
For example, say your parents bought a home for $100,000 that’s worth $400,000 by the time you inherit it. Under ordinary capital gains tax rules, you’d owe tax on the $300,000 difference between what your parents paid for it and its current value.
That could result in a huge tax bill for you, which is why the IRS allows you to use the stepped-up basis instead. Assume that you don’t sell the home right away, for instance. You hold on to the property for two years, at which time you sell it for $450,000. Taking the step-up basis of $400,000 into account, you’d only pay capital gains on tax on the $50,000 in appreciation value.
That wouldn’t allow you to completely avoid paying capital gains taxes on inherited property, but using the step-up cost basis can reduce the amount of capital gains tax you’d owe.
How to Avoid Paying Capital Gains Tax On Inherited Property
If you stand to inherit property and you want to avoid paying taxes on it, there are three possible options for minimizing or eliminating capital gains tax altogether. The first is to simply sell the property as soon as you inherit it. By selling it right away, you aren’t leaving any room for the property to appreciate in value any further. So if you inherit your parents’ home and it’s worth $250,000, selling it right away could help you avoid capital gains tax if it’s still only worth $250,000 at the time of the sale.
That may not be ideal, however, if it was your parents’ wish or your desire to keep the home in the family. In that scenario, there’s a second option you can consider.
Instead of selling the home right away, you could move into it and make it your primary residence. You could then sell the home two years later, potentially excluding some or all of the capital gains from the sale.
The IRS allows single filers to exclude up to $250,000 in capital gains from the sale of a home, increasing that to $500,000 for married couples filing a joint return. The key is that you have to live in the home for at least two of the five years preceding the sale. So if you can envision yourself living in your parents’ home for at least two years, this is another way you might be able to avoid paying capital gains tax on the property.
A third option is to not sell the property and rent it out instead of living in it. This can be a little tricky, however, since there are still tax rules you have to observe. An inherited home that’s treated as an investment property for tax purposes would still be subject to capital gains tax if you decide to sell it. But you could defer paying those taxes if you complete a 1031 exchange to purchase another investment property to replace the one you’re selling.
Disclaiming an Inheritance to Avoid Capital Gains Tax
There’s one more possibility for how to avoid paying capital gains tax on inherited property. That’s simply choosing not to inherit it at all.
This is called disclaiming an inheritance and it’s something you can choose to do if you’d prefer not to get entangled in tax issues related to someone else’s estate. The downside, of course, is that once you formally disclaim an inheritance, you can’t go back and change your mind. Whatever property you forfeited would be passed on to the next person in line to inherit.
Inheriting property can trigger capital gains tax if you choose to sell it. And there are other taxes you may need to consider, such as state inheritance taxes. If the inherited property is a residence consider living in it for a few years before selling it. Alternatively, consider renting it. Talking to an estate planning attorney or a tax professional may be helpful if you stand to inherit assets from your parents or anyone else and you’re worried about owing Uncle Sam.
Tips for Estate Planning
- Consider working with a financial advisor to put together an estate plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Property taxes in America are collected by local governments as well as the federal government. The money collected is generally used to support community safety, schools, infrastructure and other public projects. A property tax calculator can help you better understand the average cost of property taxes in your state and county.
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