Figuring out your tax obligations is always stressful. When you’re already dealing with the loss of a loved one, understanding the tax side of inheriting a house can be even more difficult.
While your tax situation is going to be different from normal, you can deter some of that stress simply by knowing what to expect. Understanding the tax treatment of an inherited property is the first step when Uncle Sam comes calling.
Inheritance Tax: What Is It And Can I Avoid Paying It?
Inheritance tax is a tax imposed on the beneficiary of an estate — the person who inherits the home or other assets. It’s a tax that’s imposed at the state level, and the amount of the tax varies from one state to another. As of 2018, only these five states have inheritance taxes.
Each state also has special rules about exemptions. Most based those exemptions on how closely related you are to the decedent.
For instance, spouses and children typically are not subject to inheritance taxes, even if the state imposes one. Of course, the inheritance tax rules can, and do, change. For instance, New Jersey repealed its 74-year-old inheritance tax in 2018.
If you’re inheriting a house, talking to a tax specialist (and doing a little online research about your state) can help you get a general idea of whether you’ll owe inheritance tax or not.
Capital Gains Tax: What Is It And Can I Avoid Paying It?
Capital gains tax is a tax you pay on the profit you make from the sale of an investment, including an inherited property. The amount of capital gains you pay on an inherited house depends on what you do with that house.
Generally speaking, if you fix it up and add a lot of value that increases its market value at the time of sale, you’ll have to pay taxes on that increase. If you sell the home at market value, you won’t be obligated to pay capital gains tax on the sale.
You can avoid capital gains tax by living in your home as your primary residence for at least two of the next consecutive five years. For example, if you decide to rent the home for two or three years and then move into it as your primary home, you could avoid capital gains taxes.
Of course, as with any tax rules, the capital gains exemption can change at any time. It’s not a good idea to count on the current law when determining a long-range plan for inherited property.
Step-up Basis and Taxes
When you’re inheriting a house, there’s a good chance it’s worth a lot more than what your loved one paid for it. Selling the property could leave you with a huge capital gains tax bill.
The step-up basis is a big benefit for heirs because it “resets” the property value to its value on the date you take ownership. That means when you sell it, you’ll only be taxed on any amount you receive over that “reset” amount (or step-up basis).
Let’s say you inherit your Grandmother’s house upon her death. She paid $60,000 for 30 years ago. But when you inherit the property, it’s worth $250,000. If you sell it for $275,000, you would make approximately $215,000.
That means you owe capital gains tax on $215,000.
Now let’s look at an inheritance with the step-up basis applied. You inherit your Grandmother’s 30-year-old house that she originally paid $60,000 for. As of the day of her passing, it’s worth $250,000. This is your stepped-up basis. So now, if you sell the property for $275,000, you are only paying capital gains tax on $25,000.
Taxes Are Complicated
It’s very easy to make mistakes that can wind up triggering penalties or even an audit. If you’re inheriting a house, speaking with a licensed and experienced tax professional is the best way to make sure you pay all the taxes you owe and none you don’t have to.