When you inherit anything, whether money, property, or something else, it can help you financially, and it’s a windfall. At the same time, inheritance can also make your taxes more difficult. If you inherit assets, such as property, you don’t typically owe taxes unless and until you sell them. Then, your capital gains taxes are calculated based on a stepped-up cost basis.
That means you pay taxes only on the appreciation once you inherit the property. If you’re selling an inherited property, you may need to work with a financial advisor.
Inheriting property doesn’t mean you automatically pay taxes. Three primary tax types apply to inheritance.
- The first is inheritance taxes, which an heir would pay on the value of an inherited estate. There aren’t federal inheritance taxes. Only six states require you to pay any type of inheritance tax.
- Then, there are estate taxes. These are paid out of the estate before anyone inherits from it. There’s a minimum threshold to pay estate taxes, which was $11.7 million in 2021, so it will not affect most people.
- The one area of taxes that does affect people when they inherit something more often is capital gains taxes. These taxes are paid on asset appreciation for something you inherit through an estate. You’re responsible for these taxes only once you sell the asset for a gain, but not when you inherit it.
If you inherit property, including real estate, the IRS uses a stepped-up basis for that asset. This means for purposes of your taxes, the base price of the asset rests on the value on the day you inherited it. You don't owe taxes if you inherit real estate and sell it immediately. Capital gains taxes are paid once you sell the property and only on the profit when you make the sale.
Two prices come into play when establishing capital gains taxes. First is the sales price. This is how much you sold the asset for. The original cost basis is how much you bought it for.
If you have real estate, this is different.
If your grandparents bought a house for $100,000 many years ago and now it’s worth $500,000, they would pay capital gains taxes for the $400,000 profit if they were to sell it.
If, instead, your grandparents passed away and left their house to you, the IRS considers the house’s original cost basis stepped up to the current market value. If you held the house for a year, and the price goes up during that year by 50,000, you owe capital gains only on that $50,000. Because of the stepped-up basis, it’s pretty rare for an heir to pay substantial taxes on an inheritance.
Capital gains taxes get very complicated, though, and it’s a good idea to work with a financial advisor if you’ve inherited property and then have sold it or plan to sell it.
You can avoid paying capital gains on inherited properties through different approaches and don’t automatically pay taxes on inherited properties.