The payment of tax on any capital gain is determined by the difference between the sale price and the cost basis. The basis of a property you buy is what you paid for it, plus costs and improvements. For example, if you purchase a property for $300,000, pay expenses of $10,000 for the transaction, and later spend $50,000 in improvements, your basis in the property is $360,000. If you sell the real estate asset for $410,000, you have gained $50,000, on which you would owe taxes.
If you inherit property, the basis is the value of that property on the date the previous owner died. Suppose that you buy the property for $300,000 and make improvements at the cost of $100,000, for a basis of $400,000. If you give that property to your best friend, the basis for that person today is $400,000. However, if you hold the property for a few years and leave it to your friend as an inheritance, the value may increase so that when you die, the fair market value is $600,000. Now, your friend inherits the property with a much higher basis. This higher tax basis is an advantage from a tax perspective. The period of appreciation in the property occurred while you owned the property, so the heir does not pay taxes on it.
From a taxpayer perspective, one of the approaches to avoiding capital gains tax on inherited property is usually selling right away. Suppose you inherit a property with a tax basis of $1 million, and you sell at $1 million. In that case, it does not matter if the entire $1 million is profit to you; you won't owe a capital gains tax because there is no difference between the sale price and the tax basis. If you hold the property for ten years and sell at $2 million, you will then owe taxes on the capital gain of $1 million due to the difference between the sale price and the tax basis.
A second option is to live in the property for at least two of the next five years, and then you can claim the personal residence exemption. This strategy might make sense if the inherited property is a fixer-upper, for example, but one that you also want to occupy. If the property has high potential and you don't want to sell it right away, this approach is worth considering.
Finally, you can convert the inherited property into an investment and keep it. If you don't sell the asset, you don't realize a gain and thus don't incur the capital gains tax. If you inherit a single or multi-family housing unit, you can maintain it as a rental property. The basis is still the fair market value of the property when the previous owner died, and you can benefit from the depreciation as it ages, as well as from the cost of improvements you provide. If you do want to relinquish the property (perhaps due to property type or for some other reason), you may still be able to avoid paying the capital gains tax by considering a 1031 exchange or alternate qualified investment approach. Remember to consult your tax advisor.
Download the Capital Gains Calculator