Does an Estate Pay Taxes on the Sale of a Home?

Posted Mar 9, 2023

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Inheriting a home after someone close to you dies can bring significant financial benefits, but it also may come with tax liabilities if you sell the home after receiving it as part of the decedent’s estate.

It takes some planning to avoid leaving your heirs on the hook for a capital gains tax liability for inherited real property that they plan to sell. Let’s take a look at some considerations during the estate planning process that could help maximize tax savings for your heirs.

Timing is Crucial For Heirs Who Sell an Inherited Home

The timing of disposition is important if your heirs want to avoid paying capital gains taxes generated from the sale of an inherited home.

When you leave your personal residence to your heirs as part of your estate, they’ll receive the property at a stepped-up basis to its current fair market value (FMV). So if you paid $250,000 for your home but its FMV is $500,000, that’s the value at which they’ll receive the property. Your heirs can sell the home for that amount and not generate a capital gains tax liability.

However, if the heirs hold the property for another year and eventually sell it for $550,000, they’ll create a taxable event on the additional gain of $50,000. Depending on actual hold time, your heirs would pay either short-term (less than 12 months) or long-term (more than one year) capital gains tax. Short-term gains are taxed as ordinary income, while long-term capital gains are taxed at more favorable rates of 0, 15, or 20 percent depending on filing status and annual income.

Another way to potentially avoid creating a taxable event on the sale of an inherited home is to live in it for at least two years in order to qualify for the capital gains exclusion on the sale of personal residences. Married couples can exclude $500,000, while single taxpayers can exclude $250,000, provided they meet the usage and ownership requirements.

A third option would be to rent out the house for a few years and then complete a 1031 exchange to defer capital gains on the sale of the investment property.

Does The Decedent’s Estate Pay Taxes on the Sale of His or Her Home?

If you want your estate and not your heirs to pay for any potential capital gains taxes, you’ll want to ensure the asset is sold as part of your estate distributions.
As noted, your heirs can avoid capital gains taxes by selling the asset as soon as they inherit it so it doesn’t incur any additional appreciation, or they can use it as their personal residence for a few years. However, having the executor sell the property while administering your estate distributions creates a much different tax treatment for the asset.

If you provide for the sale of your home as part of your estate plan so that cash is distributed to your beneficiaries, your home is treated as a capital investment asset even if it was your personal residence. Any gain realized from the sale of the home is treated as a short or long-term capital gain and taxed accordingly.

While this tax strategy avoids leaving any potential tax liabilities for your heirs, it could be disadvantageous for highly appreciated real property assets. For example, if you purchased your home 15 years ago for $150,000 and your estate executor sold it for $500,000, your estate would be on the hook for the $350,000 in realized capital gains. At 15 percent long-term capital gains tax rate, that would be a tax bill of $52,500.

Putting it all Together

When planning your estate, it’s important to consider the tax treatment of your personal residence. You can ensure your heirs don’t incur any capital gains tax penalties by divesting the asset when your affairs are being settled through probate, but your estate will be liable for any long-term capital gains taxes realized from the sale.

Alternatively, if you bequeath the home, your heirs can sell the asset immediately and not generate a taxable event since they’ll receive the property at a stepped-up basis to its current fair market value. They also can live in the home for a few years and claim a Section 121 exclusion on taxable gains from the sale of personal residences, or rent it out and complete a 1031 exchange to defer capital gains taxes on the sale of the investment property.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Hypothetical examples shown are for illustrative purposes only.

Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

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