Legally Avoid Paying Taxes on Inherited Property + FAQs

Lana Dolyna, EA, CTC
Lana Dolyna, EA, CTC

Senior Tax Advisor

When you receive a home or a piece of property through an inheritance, there can be some major financial benefits for you to consider. Do you want to move into the home and not have a mortgage, or would you like to use it as an investment property?

Many people sell the inherited property and then use the proceeds to fund something else. The options are nearly limitless. However, there are also tax ramifications that you will have to consider, especially if you plan to sell the property.

Fortunately, there are some completely legal ways to avoid paying taxes on inherited properties. Understanding these techniques not only allows you to get the most out of your property but also ensures that you are legally keeping as much money as possible in your pocket.

How Capital Gains Are Taxed on Inherited Properties

The federal government doesn’t levy inheritance taxes on when you inherit a property and only six states levy any sort of inheritance taxes on their citizens. That means that you don’t have to worry about paying capital gains taxes on your inherited property until you sell it.

Legally speaking, capital gains taxes are paid on “the appreciation of any assets that an heir inherits through an estate. Essentially, capital gains are taxes that are accrued once you have sold the property and received financial gain.

If you choose to live in the property, there are no federal tax ramifications, and if you use the property as an income-generator, capital gains taxes do not apply, but there are other types of taxes you will be required to pay.

Calculating Capital Gains Taxes on Inherited Property

Understanding how capital gains taxes are calculated is an important part of determining what you want to do with the property. It’s important to know that if you inherit a property and then sell it for $500,000, that does not mean that you are responsible for paying a capital gains tax on all $500,000.

Instead, the IRS uses what is referred to as a “stepped-up basis.” The determination of your capital gains total will depend on the difference in the fair market value of the property and your sell price.

This means that if you inherit a property with a fair market value of $400,000 and then sell it for $500,000, you are responsible for paying capital gains taxes on $100,000. The federal government has other measurements in place to consider, such as how long you’ve owned the property.

5 Ways to Avoid Paying Taxes on Inherited Property

There are legal ways for you to avoid capital gains taxes on property that you inherit.

Understanding these tools is important, as you want to be sure that you’re complying with all federal and state income tax regulations. Failure to do so could end with heavy fines and even prison time.

1. Sell the Inherited Property as Soon as Possible

This one can be a little difficult, because there are some situations when holding onto a property can be beneficial, but that’s rare. Instead, you should look to move the property quickly.

The step-up basis means that you are only held responsible for the market value of the home on the day of the testator’s death.

That means that if you inherit a home that is worth $250,000 in a fair market and you sell it for $250,000, you can pocket that money without worrying about tax ramifications, as you didn’t gain any capital.

2. Turn the Inherited Home into a Rental Property

Turning an inherited house into a rental property is a great strategy for avoiding capital gains taxes completely. You certainly don’t have to sell a home that you inherit, so using it as a rental property is a great choice.

Not only is it useful to have a monthly stream of income coming in from a property, but the tax benefits are numerous. There are taxes that focus on landlords, but they are generally much lower than capital gains taxes.

If you don’t think you have time to manage a rental property, consider employing a property manager to handle maintenance issues and the other aspects of being a landlord.

3. Use the Inherited Property as a Primary Residence

What if you don’t want to sell the property, or you also don’t want to use it to generate more rental income? You can always move into the home. If you use a home as your primary residence, you are not responsible for paying capital gains taxes on it.

Thanks to the current IRS tax codes, you simply must live in the home for a period of two years to avoid capital gains taxes on it. That means that moving into an inherited property for 24 months and then selling it will result in no capital gains taxes.

4. 1031 Exchange

Turning an inherited house into a rental property is a great strategy for avoiding capital gains taxes completely. You certainly don’t have to sell a home that you inherit, so using it as a rental property is a great choice.

Not only is it useful to have a monthly stream of income coming in from a property, but the tax benefits are numerous. There are taxes that focus on landlords, but they are generally much lower than capital gains taxes.

If you don’t think you have time to manage a rental property, consider employing a property manager to handle maintenance issues and the other aspects of being a landlord.

5. Disclaim the Inheritance

Finally, you are legally allowed to disclaim any inheritance that you receive. However, it’s important that you follow the legal path for doing so. You must begin by putting the inheritance disclaimer in writing and having the disclaimer delivered to the individual who is in charge of the estate, usually a trustee or executor.

This disclaimer and delivery must be completed within nine months of the death of the individual who left you the property, or nine months after you turn 21 if you are a minor. Most importantly, you cannot accept any benefit from the property that you are disclaiming or your disclaimer is invalid.

How to Report the Sale of Inherited Property on Your Tax Return

If you sell the property for a capital gain, it’s vital that you know how to legally claim the income on your federal tax return. According to the IRS website, there are multiple places where you are required to claim this.

You are required to report the income on a Schedule D (Form 1040), Capital Gains and Loss, as well as on Form 8949, which is a form that focuses on Sales and Other Dispositions of Capital Assets. These forms are available on the IRS website, but it is recommended that you work with a tax professional to ensure that you claim everything that you are required to claim.

FAQs

Here are the answers to some common questions about avoiding having to pay capital gains on inherited property.

The actual percentage varies based on how long you’ve owned the property and the amount that you earned from its sell.

Capital gains taxes are taxed to the beneficiary, as he or she is the person who has received a capital gain from the sell of a property gifted to them by the estate.

It is better to give a property to someone through an inheritance, as the capital gains tax rates are friendlier than those associated with the sell of a gifted property.

If there are multiple heirs to the property, the capital gains are divided among them. For instance, if three people inherit a property and sell it, the capital gains rate is divided three ways.

Yes. Failure to do so constitutes tax fraud, which carries the threat of hefty fines and time in federal prison. 

Since real estate transfers are public record, it’s not hard for the IRS to find out if you inherited a property.