In California, inheriting real property can be one of the most valuable assets passed down by a loved one. However, selling inherited real estate that has appreciated in value can lead to capital gains tax consequences. If you're worried about these tax implications, here's how you can avoid paying capital gains tax on inherited property.
Understanding Step-Up in Basis
When you sell real estate, any difference between the sale price and the original purchase price is subject to capital gains tax. However, as an heir, you may qualify for a "step-up in basis" when it comes to tax liability. This means that instead of using the original purchase price to calculate capital gains, the IRS will consider the property's fair market value at the time of the Trustor's death.
Let's say your parents bought a home in the 1960s for $30,000, and by the time they pass away, its value has increased to $430,000. Normally, you would owe capital gains tax on the $400,000 difference. However, with the step-up in basis, you would only owe tax on the difference between the inherited property's fair market value and the sale price.
How to Avoid Paying Capital Gains Tax on Inheritance
Many heirs seek ways to reduce or eliminate their capital gains tax liability. Here are five effective strategies to help you avoid paying capital gains tax on inherited property.
1. Sell the Inherited Property Quickly
One option is to sell the inherited property immediately. If you sell the property for the same value at which you inherited it, there will be no capital gain. Additionally, if the property's value decreases and you sell it for less than its inherited value, you won't incur any capital gains tax. Keep in mind that the tax rate for inherited property is determined by your income bracket.
2. Make the Inherited Property Your Primary Residence
Another way to avoid paying capital gains tax on an inherited property is by using it as your primary residence. The Section 121 Exclusion allows you to exclude up to $250,000 (or $500,000 for joint returns) of the capital gain from the sale if you have lived in the property for at least two of the five years prior to the sale. However, if you have sold another primary residence within the two years before selling the inherited property, you may not be eligible for this exclusion.
3. Rent Out the Inherited Property
If you don't plan to live in the inherited property immediately, consider turning it into a rental. By doing so, you can defer paying taxes by conducting a 1031 tax-deferred exchange. This means that if you sell the rental property and use the proceeds to purchase another investment property, you won't have to pay capital gains tax. However, if you choose not to purchase another rental property, you will be assessed for capital gains tax upon selling the property.
4. Disclaim the Inherited Property
To avoid capital gains tax on inherited real estate, you have the option to disclaim the inheritance. By signing a Disclaimer with your attorney, you voluntarily choose not to inherit the property to prevent negative tax consequences, such as being placed in a higher tax bracket. It's important to note that this decision is final and cannot be reversed. The disclaimed property will then go to the next person in line to inherit.
5. Deduct Selling Expenses from Capital Gains
Finally, you can reduce your capital gains tax liability by deducting any expenses incurred from preparing the house for sale or closing costs. For example, if you sell the home for $400,000 and its fair market value on the date of your inheritance was $350,000, you only have $50,000 in capital gains. However, by subtracting the closing costs of $40,000, your capital gains will be reduced to $10,000.
Remember, seeking advice from an experienced estate planning attorney and CPA can provide you with an ideal strategy to reduce or avoid taxes after inheriting real estate. If you have any questions about how to avoid paying capital gains tax on inherited property, feel free to contact our law firm.