Can I Avoid Capital Gains Tax on Inherited Property?

If you recently you inherited a property and are weighing the pros and cons of selling it, you should consider the possibility of having to pay capital gains taxes on its sale. Fortunately, there are ways you can avoid paying taxes on inherited property. 

Inheriting property can cause some issues for recipients regarding capital gains taxes. If you want to avoid capital gains taxes, you can sell the property immediately for its fair market value. Inheritance recipients can also make the inherited property their primary residence, avoiding the process of selling it and paying capital gains taxes. You might also choose to rent out the inherited property, earning money in the process. Inheritance recipients also avoid or minimize capital gains taxes by disclaiming inherited properties or deducting closing costs from the sale of those properties. 

To learn more about avoiding capital gains taxes on inherited property, call the tax CPAs at US Tax Help today at (541) 362-9127. 

How Can I Avoid Capital Gains Tax on Inherited Property? 

There are four ways you can avoid capital gains tax on an inherited property. You can sell it right away, live there and make it your primary residence, rent it out to tenants, or disclaim the inherited property. You might also be able to reduce the capital gains from the sale of inherited property by deducting closing costs. 

Make the Inherited Property Your Primary Residence 

If you inherit property from a loved one and live in it for a certain period of time before selling it, you might be able to avoid some or all of the capital gains imposed on a future sale. The IRS allows single taxpayers that make an inherited property their primary residence for at least two years of the five years preceding the sale of the property to exclude up to $250,000 of the capital gains from the sale. For joint filers, the exclusion is $500,000. Depending on the property’s value, this exclusion might enable you to avoid capital gains taxes on the sale of inherited property entirely. 

Sell the Inherited Property Immediately 

Capital gains taxes can take effect if you retain the inherited property for even a short time before selling it. When you inherit the property, your “basis” in the property is “stepped-up” to the fair market value at the time of death. Usually, the basis is what you bought the property for, but here it is what it was worth when the deceased passed away. You determine profits for tax purposes by subtracting your basis from the sale price. This means that if you sell the inherited property immediately at its fair market value, you will have no profit to be taxed. If you sell it above fair market value or make improvements, it will go up in price and result in some taxable income, treated at the long-term gains rate even if you held it less than a year. 

Rent Out the Inherited Property 

Another way to avoid capital gains taxes on inherited property is to rent it out. This can allow you to keep the property and turn it into a money-generating venture. People renting out inherited properties can retain them for years without selling them. If you want to sell an inherited property in the future and use those funds to buy another rental property, you can defer capital gains taxes through a 1031 tax-deferred exchange. If you sell the rental property and do not use the funds from the sale to purchase another, you will have to pay capital gains taxes on the sale. 

Disclaim the Inherited Property 

If you don’t want to deal with selling an inherited property or incurring capital gains taxes on its sale, you can choose to disclaim your inheritance or a portion of it. If you do this, there is no going back, so make sure you do not want to inherit the property before disclaiming it. Disclaiming an inheritance means you won’t receive it, won’t have to sell it, and won’t have to pay any capital gains taxes. 

Deduct Closing Costs from the Capital Gains 

You might be able to reduce the capital gains from the sale of inherited property by deducting closing costs. Suppose you sold a property for more than its fair market value but spent a considerable amount of money preparing it for sale. In that case, you may be able to deduct closing costs from the gains from the sale, minimizing your tax liability on inherited property. 

When Are Capital Gains Taxes Imposed on Inherited Property? 

If you inherit property from a loved one, you won’t be taxed on the inheritance. But, if you sell that property, you have a reportable event. When you inherit a house and later sell it at a loss, the deductibility of that loss depends on several factors, including how the property was used before the sale and the nature of the transaction. Here’s a breakdown based on the provided sources:

Personal Use Property

Generally, losses on the sale of personal use property, including a home that you lived in as your primary residence, are not deductible. This means if you inherit a home, live in it, and then sell it at a loss, you cannot deduct that loss on your taxes.

Investment Property

If you do not use the inherited home as your personal residence, it may be considered investment property. In this case, a loss on the sale of the property could be deductible. However, the deduction is subject to a $3,000 ($1,500 if married and filing separately) per year limitation for all capital losses.

Stepped Up Basis

The IRS allows for a “stepped-up” basis on inherited property, which means the basis of the property for tax purposes is its fair market value at the date of the previous owner’s death. If you sell the inherited property for less than its stepped-up basis, you may have a capital loss. However, if the property was used as your personal residence, the loss is generally not deductible.

Selling Immediately or Renting Out

If the inherited property is not used as a personal residence but instead is immediately sold or rented out, it’s considered investment property, and a loss from such a sale may be deductible. Courts have allowed deductions for losses on an inherited home under these circumstances, especially if efforts to sell or rent the property were made immediately following the decedent’s death.

Estate or Trust Sales

If the home is sold by the decedent’s estate or trust, rather than the title passing to the beneficiary who then sells the property, the transaction is reported on the estate or trust income tax return. If there is a loss on the sale, that loss can be used to offset other income of the estate or trust, with any excess loss passed through to the beneficiary.

Donating To Charity

An alternative to selling at a loss, which can maximize tax deductions, is donating the property to a charity. By donating, you can deduct the fair market value of the home as a tax loss, potentially offering more cost savings than deducting property taxes or selling at a loss.

In summary, the deductibility of a loss from selling an inherited house largely depends on whether the property was used as a personal residence or as investment property, and the specific circumstances of the sale. Personal use property losses are generally not deductible, while losses on investment property may be deductible within certain limitations.

Call Us for Tax Guidance Today 

Call our tax CPAs for guidance on dealing with inherited properties today at (541) 362-9127.