An inheritance is a windfall that can absolutely help one’s financial situation — but it can make your taxes difficult. If you inherit real estate or assets, unlike cash, you generally don’t owe taxes until you sell those assets. These capital gains taxes are then calculated using what is known as the enhanced cost basis. This means you only pay taxes on the appreciation that occurs after you inherit the property. A financial advisor could help you make sure you’re filing your returns correctly. Let’s analyze how capital gains on inherited properties are taxed.
If you inherit real estate, you don’t automatically pay taxes
There are three main types of taxes covering inheritances:
Death duties – These are taxes paid by an heir on the value of a property he inherits. There are no federal inheritance taxes and only six states impose any form of inheritance tax. Given the state-specific nature of inheritance taxes, this issue is outside the scope of this article.
Real estate taxes – These are taxes paid on the property itself before someone inherits from it. Property tax has a minimum threshold. In 2021 that limit was $11.7 million. As with all other tax brackets, the government only taxes the amount that exceeds this minimum, which means that if your estate is worth $11,700,001, the government will tax $1. The rest goes tax-free.
Capital gains taxes – These are taxes paid on the appreciation of any assets that an heir inherits through an estate. They only apply when you sell the assets for a profit, not when you inherit.
Cash you inherit is taxed either through inheritance taxes (where applicable) or estate taxes. In the case of inheritance taxes, it is your responsibility to file and pay this tax. In the case of an estate tax, the IRS taxes the estate directly. As a result, it is unusual for an heir to owe taxes, including income tax, on inherited cash.
The IRS does not automatically tax any other form of property you may inherit. This means that if you inherit property, shares or any other form of assets, you will generally not owe tax when you inherit. For example, if you inherit your grandparents’ house, the IRS will not tax you on the value of the property when you receive it. (There are exceptions to this rule in some special cases. Most often these exceptions apply to income-producing assets such as income investments, retirement accounts, or current businesses.)
However, you will owe capital gains taxes if you choose to sell this property.
Capital gains are taxed on a graduated basis
When you inherit property, whether it’s real estate, securities, or just about anything else, the IRS applies what’s known as stepped-up basis to that asset. This means that for tax purposes the base price of the asset is reset to its value on the day you inherited it. If you inherit property and then sell it immediately, you won’t owe taxes on those assets.
Capital gains taxes are paid when you sell an asset. They only apply to the profits (if any) you make from that sale. For example, say you buy a stock for $10. You later sell the same stock for $50. You will owe capital gains taxes on the $40 you made from this transaction.
Two values are involved in determining a capital gains tax: The sales price (how much you sold the asset for) and the original cost basis (how much you bought it for). In our example the selling price of this stock is $50 and the original cost basis is $10. You are taxed on the difference which, again, brings us to $40 of taxable income.
Now consider the scenario that your grandparents bought their house years ago for $100,000. Today it has increased in value and is worth $500,000. If they were to sell the house, they would pay $400,000 in capital gains taxes:
Sales Price ($500,000) – Original Cost Basis ($100,000) = $400,000
But instead, they die and pass your house. At the time you inherit, the IRS will consider the home’s original cost basis to have increased to current market value. This means that if you sell it right away, you won’t pay capital gains taxes:
On the other hand, say you hold the house for a year, during which time the value of that house increases by $100,000. If you sell it, you would only owe capital gains taxes on $100,000:
Sale price ($600,000) – Increased original cost basis ($500,000) = $100,000 taxable capital gain
The increased cost basis means that it is relatively rare for heirs to pay significant taxes on any amount of inheritance.
The bottom line
There are a few ways to avoid paying capital gains tax on inherited property that are worth considering if you are a beneficiary of an estate or trust. When you inherit property, the IRS applies what is known as an enhanced cost basis. You don’t automatically pay taxes on any property you inherit. If you sell, you only owe capital gains taxes on any gains the asset has made since you inherited it.
Advice on taxes
Capital gains can be one of the most complicated sections of the tax code. Fortunately a financial advisor can clarify how to best handle these situations. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisors at no cost to decide who is right for you. If you’re ready to find a counselor, start now.
Use a free federal income tax calculator to get a quick estimate of what you’ll owe “Uncle Sam.”
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