How to Avoid Paying Capital Gains Tax on Inherited Property

You’ve inherited a property, and now—like always—the IRS wants a piece of the action. Luckily, there are three clever ways to avoid paying capital gains tax on inherited property.

And let’s be real—paying taxes sucks, especially on a property gifted to you. So don’t feel bad about clawing back a few pennies from the government—trust me, they’re not hurting for money.

This article will explain how to avoid, defer, or eliminate as much capital gains tax on your inherited property as possible. And before you ask, we are playing by the tax rules, so don’t worry about doing anything illegal.

We’ll start by giving a quick explanation of what capital gains taxes are…

What Is A Capital Gains Tax On Inherited Property?

Put simply, when someone sells a property they’ve inherited, they may be subject to capital gains tax. This tax is calculated based on the difference between the sale price and the property’s cost basis.

Cost basis is what a property was originally worth minus any depreciation that has taken place since the new owner took ownership.

How to Avoid Paying Capital Gains Tax on Inherited Property

Now that we know what capital gains taxes are, how can we avoid paying those taxes?

In the next section, we’ll share five ways to avoid paying capital gains tax on inherited property. We’ll explain how the strategies work and highlight some of the pros and cons involved.

You’ll learn how to:

• Turn an inherited property into a cashflow business
• Sell at the right times to avoid higher taxes
• Use the 2-in-5 strategy to exclude capital gains from being taxed
• Postpone capital gains taxes indefinitely with the 1031 exchange
• Or pass the tax burden off to your least favorite sibling (only half-joking…).

Option #1. Keep The House As A Rental Property

If you live in a good area, with decent growth, you’re probably inheriting a house that is worth a lot, and you paid nothing for it.

Why not take the opportunity to become a landlord?

Inherited homes are probably the lowest entry barrier for real estate investing, other than wholesaling (maybe). But that’s a different animal altogether.

Here are a few reasons why it might be a good idea to keep an inherited home and rent it out:

• First, you’ll start to receive rental income, which can help offset the costs of owning the property.
• Second, you’ll avoid paying capital gains tax on the sale of the home.
• And finally, you’ll have the opportunity to build equity in the home over time.

Option #2. Sell Now or Wait 12 Months

If you’ve no desire to be a landlord, your next best bet is to just part ways with the home. You can sell it on the retail market with an agent, or try your hand at selling it yourself.

HOW you sell the property does matter, but WHEN you sell can be even more important.

I’ll use three different scenarios to explain why timing matters:

Scenario #1.

You inherit property for $300,000. You immediately sell that property for $300,000 and pay zero capital gains tax. Why?

Because you haven’t allowed the property to gain value and have sold exactly at your cost basis.

Scenario #2.

You inherit a house worth $200,000. You drag your feet, deciding whether to sell or keep it, and finally deciding to sell six months later. The house sells for $225,000, and you pay $6,250 in capital gains tax. Why?

Because the property has A. increased in value, and B. you sold it before owning it for at least 13 months.

Note: selling a home you’ve owned for 12 months or less exposes you to short-term capital gains taxes, which are set at higher rates than long-term capital gains tax.

Scenario #3.

You inherit a home worth $200,00. You’re busy with other things, and forget you wanted to sell the property. Two years pass, and you finally sell the home for $225,000 (it’s a bit neglected after all). Your tax bill is only $3,750. Why?

Because while you did see capital gains from the sale, you waited 12 months or longer before selling.

So, what did we learn? Timing is important when it comes to selling an inherited property.

Sell it too late, or too soon and you’ll pay more than you’d like in taxes.

Option #3. 1031 Exchange

Put simply, the 1031 Exchange is a tax cut for real estate investors. It allows you to reinvest any gains you’d make from selling a property into another “like-kind” property without paying capital gains tax.

Section 1031 (as it’s formally called) is one of the most powerful pieces of tax code available to investors.

Here are some benefits of the 1031 Exchange:

• You can defer capital gains taxes indefinitely
• You’ll be able to leverage appreciation to “trade up” to better investments
• You can move your portfolio out of high-tax, low-growth areas into more favorable areas easily

How To Use A 1031 Exchange

The IRS has a loose view of what it considers “like-kind” property, so you can use a 1031 Exchange to “trade up” to better properties.

Let’s say you have an old duplex (two-unit multifamily home) in Los Angeles, California, that you will sell. Your duplex is worth $2.5 million, and you have an existing note of $1 million.

You’ve sold a property before, so you expect to take a significant hit in capital gains tax (especially in states like California, Hawaii, or New Jersey). However, you’ve got a good tax guy who wants to help you use a 1031 Exchange.

With a little digging, you find an eight-unit apartment complex just outside of Austin, Texas, that you’d like to “trade up” towards. It’s listed for $4 million.

You notice that housing prices are sky-rocketing in Austin, rents are increasing steadily, and the area is hot for tech companies — this sounds like a great investment!

You sell your duplex in LA, pay off the $1 million note, and are left with $1.2 million in unrealized gains. This money gets put into escrow, and you now have 45 days to identify a replacement property and 180 days to close on the exchange property.

Your realtor is a rockstar and helps you identify and close the apartment building in 60 days. You walk away with a $3.8 million note and a cashflow property in a growing market.

Note: this is a simplified example of how a 1031 Exchange can work. Always consult a tax professional before considering using a 1031 Exchange.

Option #4. The 2-in-5 Loophole

The “2-in-5” loophole is a strategy homeowners can use to exclude $250,000 – $500,000 in capital gains from their tax liability sometimes, even upwards of $1 million in exclusions.

Don’t get too excited, though, because this loophole isn’t for everyone.

To take full advantage of the “2-in-5”, you’ll have to move into your inherited home and stay put… for two years.

Here’s how it works:

If you’ve lived in your primary residence for “an aggregate of two years out of the past five years,” you’re eligible for a Section 121 exclusion. The Section 121 exclusion allows a homeowner to exclude up to $250,000 for capital gains tax ($500,000 for a married couple).

How To Use The 2-in-5 Loophole

1. Sell the primary home that you’ve been living in for at least two of the five years prior.
2. Exclude yourself from $250,000 – $500,000 in capital gains tax (depending on your marital status.)
3. Move into the home you’ve inherited and get cozy.
4. Use the next two years to improve the home and increase its sale price.
5. After two years (and a few months) have passed since you sold your first house, list the inherited home.
6. Sell the home and again exclude yourself from $250,000 – $500,000 in capital gains tax.
7. Congratulations! You’ve ducked Uncle Sam to the tune of ~$1 million.

Option #5. Gift The Property To Someone Else

Last but not least, you can always disclaim an inherited property. That’s a fancy word that basically means you’ll give up your inheritance rights to another person.

Disclaiming an inheritance will exclude you from any inheritance or capital gains tax. After all, you can’t be stuck with capital gains tax for a property you don’t own.

You might consider this option if:

• Owning the home would complicate your finances or existing estate plan
• A sibling or other family member would benefit more from the inherited property
• You don’t need it

How to Calculate Capital Gains Taxes on Inherited Property

Let’s do some hypothetical math…

We’ve inherited a home with a fair market value of $300,000. Fair market value (FMV) is what the IRS thinks your property is valued at after you inherit.

If we sell that inherited home right away for $300,000, we would pay $0 in capital gains tax. There is no gain, thus no capital gains tax. But if we were to hold that same house for ten years, it would likely have appreciated nearly 35%.

Now our house is worth $405,000—and while we’ll gross $105,000 more after the sale, we’ll also be subject to capital gains tax. Long-term capital gains tax rates fluctuate, but we’ll pick a middle-of-the-road number: 15%.

Cost basis ($300,000) – sales price ($405,000) = capital gains ($105,000) x tax rate (15%) = $15,750

After ten years, we’d owe $15,750 in capital gains tax after the sale. Or nothing, if our house depreciates over that ten years and we sell at a loss.

Things to Consider Before Trying Avoiding Capital Gains Tax on Inherited Property

This section includes some “best practices” and “friendly warnings” that I didn’t include in the steps above. Feel free to skim past them, but I think they highlight some key things people might want to consider when they handle inherited property.

Avoid Disputes with Family

Making a nice home sale profit and avoiding taxes is a great way to elevate your financial situation. But how you do it might rub your siblings and other family members the wrong way.

An inheritance is intended to elevate the beneficiaries, but we’ve all heard about a family who has been torn apart by an inheritance dispute.

To avoid any misunderstandings or possible legal issues:

• Work with both the executor and your legal counsel to ensure you have undisputed ownership rights on the inherited property.

Always Consult a Professional

Before selling a property, trying to utilize a 1031 exchange, or even claiming an inherited property in the first place, consult a finance professional like a CPA.

A certified tax code professional can help you avoid costly mistakes or possible legal trouble. And who knows — maybe they’ll know of even more ways to avoid capital gains tax.

Wrapping Up

Avoiding paying capital gains taxes and maximizing profits are skills you can learn. They’re skills that can (and do) make millionaires out of everyday real estate investors.

Arm yourself with knowledge, hire a tax code wizard, and your inherited property can propel you into a fruitful real estate investing career. Or maybe just set you up to retire early?

Whatever your goals, at the very least, you now have the strategies and know-how to avoid paying capital gains tax on inherited property.