A Practical Guide to Capital Gains Tax for Inherited Property

Inheriting property is more than just brick, mortar, and land. It’s a legacy, a family connection, and—yes—a complicated tax scenario if you decide to sell. Navigating capital gains tax for an inherited property doesn’t have to feel like an unsolvable puzzle. Make informed decisions, preserve value, and minimize your tax burden by knowing what capital gains taxes mean for your inheritance.

The Basics of Capital Gains Tax on Inherited Property 

At its core, capital gains tax applies to profits from selling assets like real estate, stocks, or other investments. When assets are sold, the IRS calculates the tax based on the sale price and the original cost basis; essentially, the property’s purchase price is adjusted for factors like core renovations.

However, you didn’t purchase the property–you inherited it. For many Americans, their home is their most valuable asset. Family members seek to leave the home to heirs, thinking they can use it as a personal residence or sell it for their inheritance and not owe capital gains taxes.

What does that mean for you if you choose to sell it? After all, land or homes that have been in your family for years may have appreciated significantly. Plus, you may not have records of the original purchase price or what was spent on the last roof replacement or kitchen remodel.

Not to worry. Inherited properties get a significant tax advantage thanks to the stepped-up basis.

What is a Stepped-Up Basis?

A stepped-up basis is a provision that adjusts the taxable value of an inherited property to its fair market value (FMV) at the time of the decedent’s death. So, if you sell the property soon after inheriting it, you’ll likely owe little to no capital gains tax, because any appreciation in value before inheritance isn’t taxable. 

Example: 

Your grandmother purchased her home in 1970 for $50,000. At the time of her passing in 2023, the home’s FMV was $400,000. With the stepped-up basis, your cost basis becomes $400,000, not $50,000. If you sell the home for $410,000 shortly after inheriting it, you’d only owe capital gains tax on the $10,000 profit rather than $360,000.

Scenarios to Consider 

Like everything, inheriting real estate isn’t always as straightforward as this. Here are a few special cases that may influence your capital gains taxes on an inheritance.

1. Selling the Property Soon After Inheriting 

Timing is everything. If you sell the inherited property shortly after the date of death (say, within 12 months), the stepped-up basis can significantly reduce or even eliminate your capital gains tax liability. However, in a rapidly appreciating market, prices may quickly outpace the FMV at the time of death. 

You’ll want to secure a certified appraisal immediately (or as close as possible) to establish the FMV for tax purposes. The IRS relies on this current market appraisal to verify your cost basis; lacking one might result in the IRS defaulting your basis to $0 or the original purchase price, leaving you with a substantial tax hit. 

When selling, you’ll report the transaction using Form 8949 and Schedule D of your personal income tax return. Documentation, like the certified appraisal report, should be filed and kept indefinitely in case of a possible IRS inquiry. 

2. Holding the Property for Future Use or Sale

Not all heirs decide to sell immediately. If you intend to keep the property—as a new primary residence, vacation home, a rental, or simply for sentimental reasons—the stepped-up basis is still critical for the future. 

ez Home Search Chief Marketing Officer Kurt Uhlir and his wife found themselves in that situation for a mountain property.

“We opted not to sell, but we are getting the property appraised in case we do ever sell,” Uhlir said. “Otherwise, the IRS will set the cost basis at $0 or our parent’s original cost basis…either way, the capital gains tax burden would be much higher.”

In other words, Uhlir established a new cost basis by securing an FMV appraisal at the time of inheritance. Following his example, getting a certified appraisal covers all your bases, even if you intend to keep the property in the family. After all, we all don’t know what the future holds. Doing so now reduces the taxable gains if you sell the property 5, 10, or 15 years later, even if the property appreciates significantly over those years. 

3. Buying Out Siblings or Co-Heirs

If multiple heirs inherit a property, you might face the scenario of buying out others’ shares. Here’s where things get tricky:

• For Buyers: If you pay your siblings for their shares at fair market value, you’ll establish that cost as part of your overall basis in the property for future taxes and to determine the purchase price of their shares.
• For Sellers: Siblings who sell their share may be subject to capital gains tax if their proceeds exceed the stepped-up value of their inherited portion. 

An accurate and certified appraisal can ensure fairness in the buyout process and sidestep potential disputes.

Additional Factors to Consider 

Properties Held in Joint Tenancy 

The tax implications may vary if the property was owned as joint tenants with the right of survivorship (common among spouses or siblings). For example:

• If a sibling passes away, their share automatically transfers to the surviving co-owner, meaning the stepped-up basis only applies to the deceased’s portion. 
• For spouses, certain states provide reduced tax liability, but it’s always best to consult with a tax professional.

Mortgage Considerations 

Properties with outstanding mortgages introduce unique challenges. The financial strain may necessitate a quicker sale if the estate (or heirs) cannot manage mortgage payments while waiting to sell the property. Without keeping up with the mortgage payments, the new owners may face late fees or risk the lender starting the foreclosure process.

However, even in this scenario, the stepped-up basis can help minimize capital gains taxes for all named inheritors. 

Using the Primary Residence Exclusion

If you move into the inherited property and live there as your primary residence for at least two years, you may qualify for a capital gains tax exclusion when selling. Taxpayers can exclude up to $250,000 ($500,000 for married couples filing jointly) in profits on the sale of their primary residence under the IRS section 121 home exclusion. 

However, this strategy requires planning and commitment to the two-year residency rule. Again, this is another area where having a certified appraisal soon after inheriting helps cut the owed tax burden.

How to Avoid Common Pitfalls 

1. Always Secure a Certified Appraisal

Without one, the IRS has the power to reject your cost basis, leaving you with unexpected taxes. That adjustment can be as low as $0. Rely on licensed or certified appraisers who specialize in real estate valuation. The IRS will only accept certified valuations when applying on a stepped-up basis.  

2. Plan Ahead for Tax Implications

Whether selling immediately, holding the property, or buying out co-heirs, consult a financial advisor, certified public accountant (CPA), and/or attorney well before making decisions. Besides the complicated federal tax codes, states may have regulations and taxes that factor into your decision and potential inheritance taxes.

3. Keep All Documentation

Maintain appraisal reports, transaction records, and any estate-related documents indefinitely. These papers provide vital proof in the event of an IRS audit. These include any prior documents on the inherited home from the decedent.

4. Understand Local Laws and Special Arrangements

Tax implications change if the property is titled under specific legal agreements (e.g., JTWROS or community property laws in certain states). Again, professional legal and financial advice tailored to your state is essential.

What if You Do Owe Capital Gains Taxes?

In the case it all shakes out to where you have a tax obiligation to Uncle Sam, even after the stepped-up basis or other considerations, work with your financial advisor to calculate ahead what you may owe.

The actual dollar amount depends on your annual taxable income. The IRS sets the long-term capital gains tax rate based on income brackets. Depending on where your income falls in the tax brackets, you may owe 0%, 15%, or 20%. Short-term capital gains taxes are taxed the same as ordinary income taxes. Again, your individual income tax rate applies here.

Capital Gains Tax and Your Legacy 

Dealing with potential capital gains tax on inherited property isn’t what you want to think about immediately after the death of someone you love, but it influences your inheritance. You could save thousands in taxes by mastering the key rules—like the stepped-up basis. The secret? Smart timing, accurate appraisals, and a solid plan. With the right approach, you can make the most of your inheritance while keeping taxes to a minimum.

If you’ve inherited property and aren’t sure of your next steps, we’re here to help. Speak with one of our experienced real estate agents to explore your options and preserve the value of your inheritance.

Disclaimer: The information in this article should not be used as tax advice. Please seek a certified tax advisor or estate planning attorney for personalized advice regarding the tax implications for inheritances and real estate.