How to Avoid Paying Capital Gains Tax on Inherited Property

Being the beneficiary of inherited property can feel like a blessing—until the topic of tax on inherited assets enters the chat. When you inherit property, the good news is the right strategies minimize or even avoid paying capital gains tax if you choose to sell. Learn what heirs, beneficiaries, and estate planners need to know about handling tax consequences.

Understanding Capital Gains Tax on Inherited Property

Before we explore strategies for reducing the tax burden, review what capital gains tax is and how it applies to inherited property.

What is Capital Gains Tax?

Capital gains tax is the tax you owe on the profit earned from selling an asset, such as a home or other property, for more than the original purchase price. 

The situation becomes nuanced regarding inherited real estate. You, the heir, didn’t buy the property yourself. 

The IRS recognizes these specific circumstances. Instead, your starting point for calculating gains isn’t the original purchase price. The IRS allows for a “stepped-up basis” on inherited property. The heir now will owe tax based on the difference between the inherited property’s fair market value at the time of the owner’s death and the sale price.

The Step-Up in Basis Explained

The stepped-up basis is a rare silver lining in this tax scenario. Instead of being taxed on the difference between what the original owner paid for the property and the selling price, the property’s cost basis changes to its market value at the time of the previous owner’s death. That greatly reduces the taxable gains tax on inherited property.

For example, if your grandmother purchased a home 30 years ago for $100,000, and its market value is now $400,000, the stepped-up basis means your “cost basis” is $400,000, not $100,000. This drastically reduces the capital gains tax imposed when you sell.

State-by-State Variance

Capital gains tax laws may vary by state, adding an extra complexity layer. For instance, if you’re selling inherited property in Michigan, you’ll be subject to state capital gains and federal taxes. Michigan doesn’t offer unique exemptions for inherited property, though the stepped-up basis still applies. Consulting with a local tax advisor is crucial to understanding these nuances.

Strategies to Reduce or Avoid Capital Gains Tax

Slashing your tax on inherited property boils down to strategy. Here are five tried-and-true approaches to avoid capital gains taxes and keep Uncle Sam out of your pocket.

1. Immediately Sell the Property

Lower your tax bill and sell the inherited property quickly after you inherit it. Why? The step-up in basis minimizes your gains tax by setting the starting value equal to the property’s current value at the time of inheritance. You’ll be taxed on any appreciation in value after that point. The longer you hold it, the more likely you will end up paying capital gains.

Selling the inherited property immediately rather than later often means less appreciation and, as a result, fewer taxes. Timing is everything.

2. Live in the Property as Your Primary Residence

Thinking about moving? You could turn that inherited property into your primary residence to take advantage of an IRS exclusion. Section 121’s exclusion on capital gains tax is only for primary residences and is pretty generous. Depending on your filing status, you can avoid capital gains taxes on up to $250,000 in sale profits ($500,000 for married couples).

To qualify, though, you must have lived in the home for at least two years out of the five years before selling it. This strategy works best if the property is one you’d be happy to call home for a while. And you’ll still need to get the home appraised on inheritance to use the current fair market value and stepped-up basis for tax purposes.

3. Use a 1031 Exchange to Defer Taxes

If selling isn’t your style but investing is your thing, here’s an option. A 1031 exchange lets you sell the inherited property and reinvest the proceeds into a “like-kind” property. By doing this, you defer capital gains taxes until you sell the new investment property.

However, the IRS requires reinvestment in a similar property type within a specific timeframe. Work with a real estate agent or advisor familiar with these “like-kind” exchanges so you follow all the rules. A 1031 exchange can be a lifesaver if you want to expand your real estate portfolio while avoiding hefty capital gains taxes.

4. Gifting the Property Instead of Selling

You could gift the property to heirs or other beneficiaries rather than sell it. But here’s where it gets tricky. Gifting shifts the original cost basis onto the recipient. So, while you may avoid paying taxes, the recipient may face a large capital gains tax bill when they sell the property later.

This strategy makes sense if your heir is in a lower tax bracket or isn’t planning to sell the property soon. Perhaps they plan to use it as a personal residence and will end up using Section 121. It’s less about minimizing your taxes and more about preparing for the long-term financial well-being of your loved ones.

5. Donate the Property to Charity

If you’re feeling generous, donating the inherited property to a qualified charity prevents potential capital gains tax altogether. Better yet, you may qualify for a charitable deduction based on the property’s fair market value.

This isn’t just a savvy move to eliminate capital gains tax. Contribute to a cause you care about. Just make sure the charity is IRS-approved to maximize your deductions.

Reducing Capital Gains Tax Liability

Reducing the capital gains tax owed requires awareness of the tax code, careful planning, and professional guidance. Additional tactics include:

Deduct Selling Expenses

Deducting expenses incurred, like capital improvements or closing costs, minimizes the capital gains tax liability. When you sell an inherited property, real estate agent fees, title insurance, and legal fees can all be deducted from the final sale price. This can help reduce the profit on the property sale and, by extension, avoid capital gains tax.

Keep detailed records of all selling expenses to deduct them and lower the taxable gain. Work with a certified tax advisor to take advantage of all your deductions and keep yourself out of a higher tax bracket.

Consult with a Tax Professional

Let a tax advisor steer you through the complexities of capital gains tax on inherited property. Their understanding of the code and your tax situation leads to personalized guidance on the best strategies for minimizing your overall taxable income.

Additionally, they help maintain compliance with tax laws and regulations, which avoids potential penalties and fines. A chat is worth having before making any decisions about inherited property so you don’t have to pay additional taxes. 

Make the Most of Your Inherited Property

For many people, their personal residence is their most valuable asset. Receiving real estate as an inheritance is intended as a gift from the decedent’s estate. Deciding whether to move in, make it a rental property, or sell immediately has long-term financial and tax consequences. 

Taking a proactive approach will save you money and give you peace of mind as you honor the gift from a loved one. Don’t be overwhelmed when working through how to avoid paying capital gains tax on inherited property. 

Still, every situation is unique. State laws add another layer of complexity. Turn to an experienced tax professional or estate planner to personalize your approach.

Casey McKenna-Monroe

Casey McKenna has been part of the ez Home Search team for years, helping hundreds of thousands of people across the country make smarter decisions about buying or selling a home. Her writing is known for being clear, practical, and easy to understand—cutting through the noise and answering real questions people have when navigating the real estate process. Whether you’re buying your first home or planning your next move, Casey’s work is designed to help you feel more confident, informed, and in control.

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