When you inherit a property, you may question how to avoid paying capital gains tax on it. After all, no one likes paying taxes, and capital gains tax may be burdensome. In this post, we will look at how to avoid paying capital gains tax on inherited property and 7 legal strategies you may use to reduce or eliminate capital gains tax on it.
What is Capital Gains Tax?
Before we dive into the strategies for avoiding capital gains tax on inherited property, let’s first define capital gains tax and how it works.
The capital gains tax is imposed on the profit made when you sell an asset. The capital gains tax is determined by the difference between the purchase price and the sale price. So, if you make a profit, you must pay capital gains tax.
Capital gain tax can be different according to the time you keep the asset: short-term and long-term. If you keep the asset for less than 1 year and sell it, you will have the short-term capital gains tax rate which is the same as the regular income tax rate. However, if you keep your asset longer than 1 year, your capital gain is taxed at a lower rate. Normally you can expect 15%.
Inherited Property and Capital Gains Tax
When you inherit a property, you do not have to pay capital gains tax on the difference in value between when you got it and when you sold it. This is because you are not selling the property; rather, you are inheriting ownership of it.
If you sell the inherited property for a profit, you must pay capital gains tax on the difference between the sale price and the property’s worth when you inherited it. This is because you are now selling an asset that you inherited, and the profit you get from the sale is considered a capital gain.
Please keep in mind that capital gains tax and inheritance tax are not the same thing:
Capital gains tax:
- A tax on the profit made while selling a capital asset.
- Calculated as the difference between the asset’s sale price and its cost basis.
- The tax rate is calculated by the income tax bracket and the length of time the asset was held before the sale.
Inheritance tax
- levied on the inherited property’s worth
- Typically paid by the deceased person’s estate, not the inheritor
- Depending on where you reside, it may or may not be applied
7 Strategies to avoid paying capital gains tax on inherited property?
Now that we’ve examined the fundamentals of capital gains tax and how it applies to inherited property, let’s have a look at 7 strategies: how to avoid paying capital gains tax on inherited property.
Keep the property.
One approach to avoid paying capital gains tax on inherited property is to hold it and not sell it. Gifts and inheritances are not typically taxable income at the federal level.
It is important to note that inherited property may be subject to state and local taxes, even if it is not taxable under federal income tax. Only six states levy an inheritance tax now: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
When you inherit inherited property, it is not taxable under federal income tax. However, if you sell the property, you may be obliged to pay capital gains tax on any profit you make from the sale.
If you do not intend to sell the property, you will not generate a capital gain and will thus be exempt from capital gains tax. It is that simple!
But what if you have to sell it? Then hold it for at least a year before selling it to reduce capital gain taxes.
As we mentioned above, long-term capital gains tax rates are generally lower than short-term rates.
For example, if you inherited a $500,000 property. You decide to keep the property for more than a year before selling it. When you sell it, the property has increased in value and is now worth $600,000. The difference between the sale price and your basis (the worth of the property when you inherited it) is $100,000, which is your capital gain.
If you waited at least a year before selling the property, you would be eligible for the long-term capital gains tax rate, which is normally lower than the short-term rate. The specific rate you would pay would be determined by your tax bracket. For example, if your tax bracket is 22%, you would pay a 15% long-term capital gains tax rate on a $100,000 capital gain, resulting in a tax liability of $15,000.
If you sold the property within a year of inheriting it, you would have had to pay the short-term capital gains tax rate, which is normally the same as your ordinary income tax rate. If your tax bracket is 22%, you would have to pay a 22% tax rate on your $100,000 capital gain, resulting in a $22,000 tax liability.
As you can see, by keeping the property for at least a year before selling it, you would be able to benefit from the reduced long-term capital gains tax rate and lower your tax liability.
Use the property as your primary residence.
It is the most effective and straightforward method of avoiding capital gains tax.
If you inherit a house that you do not intend to sell, you can still avoid capital gains tax by making it your primary residence. You can exclude up to $250,000 in capital gains on the sale of your principal house if you are single, or up to $500,000 if you are married and file a joint return, according to IRS guidelines.
If you owned and used the property as your primary residence for at least two of the five years before the sale, you are eligible for this exception.
To qualify for the exemption, you must satisfy the following criteria:
- You must have owned the house for a minimum of two years (the “ownership test”).
- You must have lived in the house as your primary residence for at least two of the previous five years (the “use test”).
- In general, you are not qualified for the exclusion if you deducted the gain from the sale of another house within the two years before your home sale.
Because it is complicated, I will use an example.
If you sold a property on July 1, 2021, and used the primary residence rule to exclude the gain from the transaction. Then, if you sell another property on June 1, 2023, you will typically be disqualified to apply the principal residence rule to exclude the gain on the sale of the second home because the two-year period before the sale of the second home (June 1, 2023) includes the sale of the first home (July 1, 2021).
Make use of the “step-up in basis” rule
It means if you sell the property at the time, you inherited it for the market price, then you do not have to pay capital gains tax.
This implies that if you inherit a property that has increased in value since the owner’s death, you can reset the value to the higher value at the time of the owner’s death and pay capital gains tax only on the appreciation that happens after the owner’s death.
Suppose you inherit a house that was bought for $100,000 and is now worth $200,000 at the time of the owner’s death. You can reset the value of the property to $200,000 under the step-up in basis rule, and if you sell the property for $200,000, you don’t have to pay capital gains tax.
Donate the property to a charitable organization
If you do not want to keep the inherited property, you may transfer it to a charitable organization to avoid paying capital gains tax. It also assists you in deducting your taxes.
According to IRS regulations, you can claim a charitable deduction for the fair market value of the property at the time of contribution and avoid paying capital gains tax on the property’s appreciation.
If you donate property that has appreciated in value after you purchased it, your deduction may be restricted to the fair market value of the property on the date of the donation. If you donate property that has depreciated in value since you bought it, your deduction may be restricted to the item’s tax basis.
Your tax basis is normally the amount you paid for the property plus any additional charges (such as closing costs or improvements).
For example, if you inherited a $100,000 property and donate it to a nonprofit organization a year later. During that year, the property’s value dropped to $80,000. If you claim a tax deduction for the donation, you can deduct $100,000 (your tax basis in the house), even though the fair market value of the house on the date of the donation was only $80,000.
As a result, donating is an excellent approach to maximizing tax benefits and reducing taxes.
Transfer the property to a trust
By putting the property in a trust, you may shield it from capital gains tax and maintain its worth for future generations. The assets under a trust are held for the benefit of the trust’s beneficiaries.
Transferring property to a trust is typically considered a tax-free event since you are not obliged to pay capital gains tax on the transfer. This is due to the fact that the transfer is not regarded as a sale or other disposal of the property.
If you wish to reside in a trust-owned property, you should think about establishing a revocable living trust. A revocable living trust is a form of trust that allows you to keep control of the trust’s assets and make changes to it during your lifetime.
You are free to continue using and enjoying the trust-owned property as you see appropriate, including as your primary residence.
A revocable living trust has the advantage of allowing you to transfer ownership of the property to the trust without losing the ability to use and enjoy the property.
If you truly dislike the property, you may exchange it.
A 1031 exchange, also known as a “like-kind exchange” or a “Starker exchange,” is a tax method that enables you to postpone paying capital gains tax on the sale of a property by reinvesting the profits in a comparable property.
If you have a rental property that you inherited from a relative. You decide to sell the $500,000 property because you want to invest in a new rental property. You must pay capital gains tax on the difference between the sale price and your basis if you sell the property (the value of the property when you inherited it).
Instead of selling the property directly, you want to delay the capital gains tax by using a 1031 exchange. You work with a qualified intermediary, who holds the profits of the first property sale until you use them to buy the second. You identify a comparable rental property for $500,000 and accomplish the swap within the time restraints.
In this scenario, you were able to postpone paying capital gains tax on the sale of the first property by reinvesting the proceeds in a similar property via a 1031 exchange. You will not have to pay the tax until you sell the exchanged property, at which point you will have to pay capital gains tax on the difference between the sale price and your basis in the exchanged property.
Realize capital losses from other investments
If you have capital losses from other investments, you may be able to use them to offset the gain on the sale of an inherited property, lowering your capital gains tax payment. Netting your capital gains and losses is what this is called.
For example, imagine you inherited a $500,000 property and sold it for $550,000, resulting in a $50,000 capital gain. However, you also incurred $50,000 in capital losses from other investments over the year. Your net capital gain would be $0 ($50,000 gain minus $50,000 loss); thus, you would not pay any capital gain taxes.
Conclusion
Inheriting a property may be an excellent way to accumulate wealth and guarantee your financial future. However, it is very important to understand how capital gains tax would impact your capacity to sell the property and profit. You may reduce or eliminate capital gains tax on an inherited property by implementing the strategies discussed in this article, allowing you to keep more of your hard-earned money.
If you want to learn about Quebec’s welcome tax, please read this article.
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