How to Avoid Paying Capital Gains Tax on Inherited Property
Inheriting property can be a life-changing gift, but it can also come with a hefty capital gains tax. The good news is that there are steps you can take to reduce or erase the capital gains taxes on your property. You can:
- Make the inherited property your primary residence
- Sell the property immediately
- Rent the property out
- Disclaim the property
- Deduct your closing costs
Each option has unique benefits and considerations. Let’s take a closer look at them all.
Selling Inherited Property? Know the Tax Rules First.
Ways You Can Avoid Capital Gains Tax on Inherited Property
1. Make the Inherited Property Your Primary Residence
One way to avoid capital gains tax on your inherited property is to make it your primary residence. If you live in the home for at least two out of five years before selling it, you can qualify for the Primary Residence Exclusion, which allows you to exclude up to $250,000 of capital gains from your taxable income. For married couples, that exclusion goes up to $500,000! This two-year period does not need to be a consecutive 24 months.
2. Sell the Property Immediately
Selling an inherited property as soon as you can is another way to avoid the capital gains tax. When you inherit property, its cost, known in tax jargon as basis, is “stepped up,” or increased from its original cost to its fair market value at the date of the former owner’s death. If you sell the property shortly after, any capital gain should be minimal, as there will likely be little to no appreciation in value.
3. Rent the Property Out
Renting out the inherited property can provide a steady income stream and help you avoid immediate capital gains tax. While this doesn’t eliminate the tax entirely, it does defer it, giving you time to plan a more tax-efficient sale or transfer later on.
4. Disclaim the Property
Another option is to disclaim the inherited property. When you do this, the property will pass to the next heir in line, and you avoid potential capital gains tax. This strategy can be useful if you already have significant assets or if the property comes with potential liabilities. However, once you choose to disclaim an inheritance, you can’t change your mind. Before taking this step, be sure you are truly willing to give up the property for good.
5. Deduct Your Closing Costs
When you sell the inherited property, you can reduce your taxable gain by deducting closing costs such as real estate agent fees, title insurance, and legal fees. These deductions lower the amount of capital gains tax you owe by decreasing the net gain from the sale.
No matter which method you choose, keep detailed records of all your transactions, including valuations, improvements, and expenses. These documents can be crucial for accurately calculating your capital gains or losses.
When Are Capital Gains Taxes Imposed on Inherited Property?
When you inherit property, you aren’t taxed on the property right away for federal tax purposes, but there may be state taxes that apply. However, if you decide to sell the property later, you will then be taxed on any capital gains you made from the sale. If you sell it at a loss, you may be able to deduct the loss—but not always. Here’s how it works.
Personal Use Property
Capital gains taxes are typically imposed when the inherited property is sold. If the property was used personally (e.g., as a vacation home), the capital gains tax will be based on the difference between the stepped-up basis and the sale price.
Investment Property
For inherited investment properties, capital gains tax is calculated similarly to personal use property. However, investment properties may also be subject to additional taxes, such as a depreciation recapture tax of 25%, which should be considered.
If the inherited property is used for investment purposes, consider a 1031 exchange. This allows you to defer capital gains tax by reinvesting the proceeds from the sale into a similar type of property.
Stepped-Up Basis
The “stepped-up basis” significantly affects the amount of capital gains tax owed. This rule adjusts the property’s basis to its market value at the time of inheritance, reducing the taxable gain when the property is eventually sold.
Selling Immediately or Renting Out
Selling the property immediately or renting it out are common strategies to manage capital gains tax. Although selling it immediately lets you minimize gains through the stepped-up basis while renting defers the tax, offering potential future planning opportunities.
Estate or Trust Sales
Selling through an estate or trust can provide tax benefits, depending on the specific circumstances and structure of the estate or trust. Consulting with a tax professional can help determine the best approach.
Donating to Charity
Donating inherited property to charity not only eliminates capital gains tax but also provides a charitable deduction. This can be a strategic option for those looking to maximize their tax benefits while supporting a cause.
Inheriting Property? Greenback Can Help You Optimize Your Taxes!
We hope this guide has helped you understand how to avoid paying capital gains tax on inherited property. If you still have questions, we have answers!
At Greenback Expat Tax Services, we specialize in helping expats manage their tax obligations seamlessly. Founded in 2009 by US expats for expats, we understand the unique challenges of living abroad.
If you’re ready to be matched with a Greenback accountant, click the Get Started button below. For general questions on US expat taxes or working with Greenback, contact our Customer Champions.
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