How is Capital Gains Tax Calculated on Inherited Property?

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In the days following the passing of a loved one, the executor of the will and any legal representatives will divide the assets among the beneficiaries. These assets can range from stocks and cash to physical assets like houses, boats, cars, and even pets. If someone you cared for recently died – or if you are planning ahead for the future – you might be wondering how much you need to set aside for taxes.

Inheriting property involves a legal transfer process that varies depending on how the property was owned and whether the deceased had an estate plan in place. Heirs may need to navigate this process to ensure proper transfer and management of inherited assets.

How is capital gains tax calculated on an inherited property? Are there instances when you don’t have to pay taxes at all?

Financial planning doesn’t stop with death. Here is what you need to know if you expect to inherit property or already have an inherited home in your possession.

What taxes do you pay as a beneficiary? 

There are multiple types of taxes involved with the passing of a loved one, and the rules governing estate, inheritance, and capital gains taxes are set by the IRS and state authorities. The executor likely has to evaluate the value of the assets involved, settle any debts, and determine what needs to be taxed within the inheritance. Generally, certain tax procedures or thresholds apply, but there may be exceptions depending on specific circumstances. Here are three types of taxes associated with death.

Estate Tax

This one is easy. The tax is pulled from the value of the estate and should be paid before any assets are distributed to beneficiaries. The executor will take care of paying this tax. The 2026 Estate Tax Exemption is $15 million for individuals and $30 million for married couples. The federal estate tax is calculated based on the estate tax value, which is typically the fair market value of the assets at the date of death. Under IRC 1014, the basis of inherited property is generally its fair market value on the date of the previous owner’s death, or the FMV on an alternate valuation date six months later if elected for estate tax purposes. So if your loved one passed away with only $11 million in assets, they won’t owe anything on this tax.

The taxable income is only on money above the $15 million threshold. This means if your loved one had $16 million in assets, they would only pay taxes on $1 million.

Inheritance Tax 

Once the estate tax is settled, it’s time to move on to the inheritance tax. This is a tax paid by the recipient of the assets. This tax is often what worries beneficiaries because they can’t afford a large tax bill on inherited items. However, there is good news: only a limited number of states impose inheritance taxes–specifically, Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. There is no federal inheritance tax.

If you aren’t filing in any of these states, you shouldn’t have to worry about the inheritance. However, check state laws to make sure new taxes haven’t recently been passed in your area. Depending on where you live, inheritance taxes can range from 1% of the value to 20% of the value for items received.

Capital Gains Tax 

The final tax you need to consider is the capital gains tax, which is levied on the sale of your assets. If you inherit cash, you shouldn’t have to worry about this tax. However, it gets trickier if you inherit physical assets – like a house.

Receiving an inheritance is not considered a taxable event for income tax purposes. Income tax is not automatically due when you inherit property; capital gains tax is only triggered if you sell the inherited asset for a profit over the stepped-up basis.

>> AGENT ANSWERS: How to avoid capital gains tax on real estate?

You might have to pay capital gains taxes on any assets you inherit or sell, but the bill might not be as high as you think. Here’s what you need to know.

How is capital gains tax calculated?

The first step when deciding if you can avoid capital gains tax on inherited property is to learn how to calculate your expected tax bill. The cost basis (also called tax basis or base price) of inherited property is typically the fair market value at the time of inheritance, which serves as the starting point for capital gains calculations. You are only taxed on the profit (taxable gain) made from the sale of a property, not on the value of the property itself. Capital gains tax is imposed when the sale price (sale proceeds) exceeds the stepped-up basis (cost basis) of the inherited asset. Inherited assets automatically qualify for long-term capital gains treatment, regardless of how long the deceased owned the property or how quickly you sell it after their death. Income tax brackets for long-term capital gains range from 0% to 20%, depending on your overall taxable income.

Consider this example if you are selling a house (not inherited):

• You bought the home for $200,000 (your base price or cost basis).
• You sold the home for $500,000 (sale proceeds).
• The initial capital gains, or taxable gain, are $300,000.

You can see from this example how your capital gains are much lower than the home sale. The next step is to deduct various other costs related to listing the home. For example, if you paid 6% commission to the Realtors involved when selling the house, you would deduct $30,000 because that was part of the cost involved in securing the capital gains on the home. If you spent $5,000 staging and preparing the home for sale, you could deduct that, too. Using this example, the deductions bring the capital gains down to $265,000.

The final step is to subtract exclusions from the home sale. The IRS will deduct $250,000 from your tax bill if you are a single filer selling a primary residence or $500,000 if you file jointly with a partner or are considered the head of the household. This means if you live in the house full time, your capital gains bill would either be $15,000 or nothing at all.

Of course, this changes when you inherit a property. While the capital gains tax calculation process remains the same, you aren’t able to claim the primary residence exemption unless you have lived in the home for at least two years.

Capital Gains Taxes Are Applied on a Stepped-Up Basis

One of the most important things to know about your newly-inherited asset is that its value is typically adjusted to its current market value at the owner’s death for tax purposes, a process known as the step up in basis. This means the fair market value is set based on its worth at the time of your relative’s death, not what the asset was worth when the loved one bought it. The stepped-up basis rule resets the tax basis of inherited property to its fair market value on the date of the decedent’s death, so any appreciation during the previous owner’s lifetime is not taxable to the heir.

For example, the median home sale price in 1992 was $144,500. The median sale price in 2022 was $547,800. With the stepped-up basis, the IRS will set the market value at the property’s current market value at the owner’s death for tax purposes, not the original purchase price according to the deed.

Tax Benefits of Selling Immediately

This creates something of a loophole if you recently inherited the property. Selling inherited property soon after inheritance is the most reliable way to avoid paying capital gains tax, as capital gains tax applies only to appreciation that occurs after the date of inheritance. It’s not uncommon for people to sell homes immediately after they were inherited because then the profits on the home sale would be $0. If you bought a house that had an appraised value of $500,000 and sold it for $500,000 a month later, you didn’t make any taxable profits. So, if you sell the inherited property for less than its date-of-death value, you can report a capital loss to offset other taxable gains, provided certain conditions are met.

If you decide to wait to sell the home for a year or so, the new valuation will be used to evaluate your gains. So, if you sold the house for $600,000 and its fair market value was $500,000 when you inherited it, the capital gains would be $100,000 (before you deduct selling expenses, Realtor fees, and other home sale costs).

Understanding the 1031 Exchange

You have multiple options when deciding how to manage inherited real estate, including inherited land. You can sell, rent, or consider gifting inherited property to other heirs. Some people want to hold on to a family home because of the memories that come with it, while others may need to share ownership with multiple heirs and reach a unanimous agreement on what to do. If there are multiple heirs, the process of selling or managing the property can be more complex, and gifting inherited property to other heirs may have tax implications. You can also hold on to the property and use it as a source of rental income. If this is a path you are considering, learn about your 1031 Exchange options.

The IRS calls this a Like-Kind Exchange and offers to waive any capital gains on the home sale when you reinvest the proceeds into a similar property. For example, if you sell a rental property and buy a similarly-sized property to turn into a rental home in another town, you can file a 1031 Exchange.

For your inherited home, you might decide to rent it out for a few years and then eventually sell it to purchase another investment property elsewhere. The timing and method of sale can impact your tax liability. Keep in mind, this is not a tax-free deal but rather a tax deferment. When you eventually liquidate the assets (sell the property without buying anything else), you will owe capital gains tax on the home. If you move into the inherited home and make it your primary residence for at least two of the five years before selling, you may be able to avoid capital gains tax on the sale.

Tips to Streamline the Inheritance Process 

The best time to talk about estates, inheritance, and beneficiaries is when your loved ones are still alive. Understanding the rules that govern estate and inheritance tax processes, and considering other factors such as ongoing expenses, property type, and asset protection strategies, is essential for aligning with your financial goals. If you are currently preparing your will, it is best to be honest about your plans and wishes so your loved ones aren’t surprised by your assets and estate. However, not everyone has this luxury and they often have to figure out what to do with the assets of someone they love.

Here are a few tips:

Work with an objective third party you can trust. A financial advisor or tax professional shouldn’t have any agenda when giving you advice. They should provide clear information about your tax liability and help you navigate the complex rules involved.

Don’t make rash decisions. You shouldn’t feel pressured into making decisions on newly-inherited property. Give yourself time to mourn and decide what you want.

Try to be fair. Some people have families that try to take more than their share of the will. Whenever possible, follow the wishes of the deceased as closely as possible. When the wishes are vague, divide the assets as evenly as possible.

Be aware of ongoing expenses. Inherited property often comes with ongoing expenses such as property taxes, insurance, maintenance, and potential mortgage obligations, which can impact your overall financial situation.

Establish an accurate value with a qualified appraisal. Establishing an accurate value at the time of inheritance is critical for future tax calculations. Obtaining a qualified appraisal provides necessary documentation of the property’s fair market value, which is especially important for IRS reporting and potential charitable contributions.

Additionally, ask your loved ones to organize their assets. No one wants to think about death, but it is the eventual reality for all of us. Take time to prepare your will and organize your finances when you are alive so you can help the people you leave behind.

Talk to a Realtor About Capital Gains Taxes

If a loved one recently passed away and you are worried that you might have to pay capital gains tax on their assets, consult a Realtor.

Real estate agents work with inherited estates frequently and can offer you advice based on their experiences, including how property taxes and property tax rates – which can vary significantly by location – should be considered when evaluating inherited property. An expert agent can help you understand the fair market value of a home and explain how federal tax, such as capital gains tax and estate tax, may apply depending on the value of the estate and the sale of the property.

They can also provide advice on whether you could benefit from selling the same property, making it a primary residence, or making capital improvements, which can increase the property’s tax basis and reduce future capital gains tax liability.

Additionally, in common law states, typically only the deceased spouse’s 50% share of the same property gets stepped up in basis. If you choose to donate inherited property to a qualified charity, you can eliminate capital gains tax entirely and receive an income tax deduction equal to the property’s fair market value at the time of donation.

To find a Realtor near you, turn to the experts at FastExpert. We pair sellers with the top agents in their area. Discover the top real estate agents near you and see if capital gains taxes could affect your assets.