While tax liability is likely not going to be your first thought when you inherit a property from a loved one, it should be a consideration eventually. Unfortunately, the current capital gains tax rates can end up costing you thousands of dollars when you eventually go to sell the property.
With that in mind, here is a guide on how to avoid paying capital gains tax on inherited property. Keep reading to learn what options you have available to you and how to reduce your overall tax bill. While not every scenario will likely make sense for you, you should be able to find at least one option that will be a good fit.
Steps to take to avoid paying capital gains tax
Fortunately, if you want to limit your liability for the coming tax year, there are a couple of ways to do it. We've laid them out below so you can determine which option will work best for you.
Sell the inherited asset right away
The first option to avoid capital gains tax liability is to sell the asset right away. Since the IRS allows you to use an adjusted basis, or stepped-up tax basis, for inherited property for calculating your tax liability, which allows you to use the value of the property when you inherited it versus when it was first purchased, selling the home immediately should do away with any tax liability.
In this case, selling the home immediately precludes it from appreciating any further. For example, if the fair market value of the home was $300,000 when you inherited it, the property should still be worth $300,000 when you put it up for sale a few weeks later, which would eliminate any taxable gain.
That said, this method may be less than ideal if your loved one's dying wish was to keep the real estate in the family.
Turn it into your primary residence
Another method is to turn the inherited property into your primary residence and to live in it for at least two years.
Put simply, according to current tax law, much of the income from the sale of a primary residence is excluded from being taxed as a capital gain. A single filer is allowed to exclude up to $250,000 of profit from their tax bill as long as they are selling a primary residence, according to current tax rules. That number goes up to $500,000 for married couples filing jointly.
The key here is that you have to live in the property for at least two years before selling in order for it to be considered a primary residence. Otherwise, you will face either the short-term or long-term capital gains tax rate, depending on how long you lived in the property.
Make it into an investment property
That's said, if you don't want to live in the property, you can always make the capital asset into a rental property instead. Technically, you will still face the capital gains tax rate when you eventually go to sell the property. However, at that point, you would have the option of doing a 1031 exchange and swapping the inherited asset for a like-kind investment property in order to defer any taxable gains.
Disclaim the inherited asset for tax purposes
Finally, you have the option of disclaiming the real estate for tax purposes. Essentially, that means that you would forfeit your claim on the capital asset to ensure you'll face a smaller tax bill this year. The asset would then go to the next person in line to inherit it instead.
What not to do when facing inheritance tax
Now that you have a better idea of what you can do to improve the look of your tax return, the next step is to learn what not to do. Here are a few mistakes people make when it comes to estate planning and capital gains tax liability. Read on so you can avoid falling into similar traps.
Don't underestimate your capital gains tax liability
The biggest mistake many wealthy Americans make when it comes to estate planning is underestimating their capital gains tax liability.
Remember, a short-term capital gain, which occurs when the asset is held for less than a year, is taxed as ordinary income. If you hold the asset for longer than a year, your long-term capital gains tax rate will depend on your tax bracket. However, typically, a long-term capital gain is taxed at either 15% or 20%.
Don't try to avoid taxable gain by gifting the house
Sometimes parents will try to avoid taxable gain by gifting the property to their child while they are still alive. Unfortunately, though, this move can have a tax consequence of its own. In this case, gifting the property to the child would preclude them from using a step-up tax basis for the appreciated value of the asset, meaning that it could leave them with a bigger taxable gain.
Don't underestimate the value of an estate planning attorney
Lastly, be careful not to underestimate the value of an estate planning attorney. Particularly when you're dealing with a lot of taxable income, it makes sense to get an expert opinion. If you're unsure of which route to take with your estate plan or how to handle an inherited asset, consulting with an attorney can be an invaluable next step.
The bottom line on capital gain tax
In truth, there's very little reason why he should have to pay capital gains tax on an inherited piece of real estate. When you get down to it, there are quite a few different ways that you can work to reduce your tax liability for an inherited asset.
With that in mind, use this as your guide for how to avoid paying capital gains tax on inherited property. Armed with this knowledge, you should be able to significantly reduce your tax bill for the coming tax year.