What to Know About the Tax Basis of Inherited Property

Losing a loved one is never easy. Inheriting their property can bring a mix of emotions and financial questions. The sentimental value is priceless, but the reality is real estate has a cost even if you didn’t buy it yourself. Anyone settling an estate must know about the tax basis of inherited property, regardless of whether they choose to keep or sell the home. 

Are you unsure what tax basis means and what its implications are for you? Shine some light on why it matters and its impact on your inheritance.

What is the Tax Basis of Inherited Property?

The tax basis serves as the starting point for determining potential capital gains taxes if the property is eventually sold. It’s also known as cost basis.

Essentially, the Internal Revenue Service (IRS) defines the cost basis as an asset’s value plus any additional costs. For tax purposes, the basis represents the property’s value plus any additional costs associated with essential maintenance or the sale.

Why the Tax Basis Matters

How inherited properties are taxed directly influences the capital gains tax owed when you decide to sell inherited assets. It doesn’t matter if you sell shortly after the decedent’s death or ten years later. You’ll still owe capital gains.

Capital gains tax is calculated as the difference between the selling price and the property’s cost basis.

Long-Term vs. Short-Term Capital Gains

The good news for heirs is that inherited properties are classified as long-term assets, regardless of how long you hold onto them before selling. Long-term capital gains are taxed at lower rates than short-term gains, making this classification a financial advantage for heirs. If it was short-term, it could drastically change what you owed in annual income tax.

Now, let’s say the home’s original purchase price was $150,000. Your loved one lived in the property for almost 20 years. In that time, thanks to real estate appreciation and improvements, the value of the property when you sell it now is $500,000. Your parents didn’t keep the most accurate records, so even though you know they replaced the roof, added a swimming pool, and renovated the kitchen, you can’t find the receipts that would help shift this original cost basis. That means you could owe taxes on $350,000. At a 15% tax rate, that’s $52,500.

Step-Up in Basis Rule

Before worrying about how much you’ll pay to the IRS, take a breath. The tax code has a special provision for inherited property. 

Introducing the step-up basis rule. The property’s original cost basis can be adjusted to reflect the fair market value at the time of the decedent’s passing. When you inherit a property, its cost basis shifts to reflect its fair market value (FMV) on the date of the decedent’s death. This means that, rather than calculating the capital gains tax on what the deceased initially paid for the property, it uses current home values.

For example, if a parent purchased a house for $100,000 in 1980, but its FMV was $400,000 at the time of their death, the stepped-up cost basis makes it $400,000. This adjustment works to reduce the taxable gains if you sell the property in the future.

Example Calculation

However, be aware heirs may need to pay income tax on the capital gains that arise from the increase in property value after inheritance. So, if you hold the property for a time before selling it, your capital gains are calculated on the home’s appreciated value from that stepped-up basis to the sale date. Still, that’s much improved over the original cost basis.

Let’s say you establish a stepped-up tax basis of $400,000. If you sell the home two years later for $450,000, your taxable gain is $50,000. Assuming the sale is categorized under long-term gains, you would be taxed at the applicable long-term capital gains rate on the $50,000 profit rather than the entire sale amount. This $50,000 gain contributes to your taxable income.

How to Determine the Cost Basis of Inherited Property

Anyone inheriting real estate must establish a new fair market value immediately. It will help you save thousands in taxes whenever a sale happens.

Fair Market Value (FMV) at the Date of Death

The FMV relies on the property’s appraised value at the decedent’s death. This figure is typically obtained through a professional appraisal or the property’s current market analysis. Hire an appraiser or run a comparable market analysis. Keep these reports in a safe place. You’ll need them to prove the stepped-up basis.

Alternate Valuation Date

Under certain conditions, the estate may opt to use an alternate valuation date, which is six months after the date of death. This option is sometimes chosen if the property’s value depreciates, as it can lower the estate’s overall value for estate tax purposes. Note that the executor must explicitly claim this option.

How Improvements and Depreciation Affect the Cost Base

Any renovations made to the property after the inheritance may increase the cost basis. Conversely, if you’ve used the property to generate rental income, depreciation claimed during that period will decrease the basis. Keep accurate records of all such expenses and depreciation.

Difference Between Gifted and Inherited Property Basis

There is a distinction between inherited property and gifted property in the tax code for the cost basis. Unlike inherited property, the tax basis of a gifted property remains the same as the original owner’s, known as a carryover basis. This means if the same $150,000 home were gifted to you during your parent’s lifetime, its tax basis would still be $150,000—not the FMV at the time of the gift. As you can imagine, that changes the tax implications of selling the property.

Special Situations and Exceptions

State-Specific Considerations

While the federal government does not impose an inheritance tax, some states have their own taxes or differing rules regarding the tax basis of inherited property. Heirs who inherit real estate in these states should review local tax regulations. As of 2024, those states are Kentucky, Maryland, Iowa, Nebraska, New Jersey, and Pennsylvania.

Community Property States

In real estate holdings in these nine states (including California and Texas), a surviving spouse may qualify for a full step-up based on the entire property value, even if they only inherited half of it because of intestate laws. This rule provides substantial tax benefits to beneficiaries in these states.

Jointly Owned Property

The rules for determining the tax basis for jointly owned property depend on the ownership structure and intestate laws. For example, in cases of joint tenancy or tenants in common, only the deceased person’s share of the property receives a step-up in basis.

Strategies to Minimize Taxes on Inherited Property

This provision in the tax code already helps those dealing with grief and handling inheritances. Additional strategies can further minimize the tax burden:

Holding vs. Selling

Holding onto the inherited property before selling sometimes allows the market value to appreciate further, particularly if local property values are rising. However, consider any carrying costs, including property taxes and maintenance. Estimating how the new FMV of the property changes the capital gains tax is worth it for planning purposes.

1031 Exchange for Real Estate Investments

If you’re inheriting real estate and planning to reinvest in another piece of real estate, a 1031 exchange helps defer capital gains taxes. This option reinvests the sale proceeds into “like-kind” property without triggering capital gains taxation.

Charitable Donations

Donating a portion of the property or using it for charitable purposes can provide tax deductions and a sense of community contribution. Philanthropic donations effectively reduce overall tax burdens while supporting causes you value.

Know Your Taxes on Inherited Assets

Make informed financial decisions as an heir. The stepped-up basis rule helps minimize taxes and maximize the value of your inheritance. But, it’s vital to establish the new property value soon, even if you haven’t decided yet to hold or sell the decedent’s estate.

Given the complexities of estate administration, it is highly recommended that you consult a tax professional to avoid costly mistakes and comply with tax regulations. Additional resources and tools, such as tax calculators and estate planning guides, further assist in outlining inheritance tax considerations.