Understanding Taxes on Inherited Property
Inherited real estate receives favorable tax treatment compared to gifted or purchased property. The stepped-up basis rule reduces or eliminates capital gains taxes when heirs sell. However, several tax considerations affect decisions about what to do with inherited property. Tax laws change frequently. The information below covers general concepts. Consult a tax professional for advice specific to your situation.Stepped-Up Basis
Cost basis determines how much capital gains tax is owed when property is sold. For purchased property, basis equals the purchase price plus improvements. For inherited property, basis “steps up” to fair market value at the date of death. Example:| Scenario | Original Owner | Heir (with stepped-up basis) |
|---|---|---|
| Purchase price | $150,000 | N/A |
| Fair market value at death | $400,000 | $400,000 (new basis) |
| Sale price | N/A | $425,000 |
| Taxable gain | N/A | $25,000 |
The stepped-up basis applies regardless of what the original owner paid or how long they owned the property. Only appreciation after the date of death is taxable.
Establishing Fair Market Value
An appraisal at or near the date of death documents the stepped-up basis. This valuation protects heirs if the IRS questions the basis claimed on a future sale. Documentation to obtain:- Professional appraisal dated close to the date of death
- Comparable sales data from that time period
- Estate tax return (Form 706) if one was filed, which includes property valuations
Capital Gains When Selling
If the property sells for more than the stepped-up basis, the difference is a capital gain. The tax rate depends on how long the heir owned the property and their income level. Holding period:- Property held one year or less after inheritance: short-term capital gains (taxed as ordinary income)
- Property held more than one year: long-term capital gains (lower tax rates)
| Tax Filing Status | 0% Rate | 15% Rate | 20% Rate |
|---|---|---|---|
| Single | Up to $47,025 | $47,026 - $518,900 | Over $518,900 |
| Married Filing Jointly | Up to $94,050 | $94,051 - $583,750 | Over $583,750 |
These thresholds apply to taxable income, not the gain itself. High-income taxpayers may also owe the 3.8% Net Investment Income Tax on capital gains.
Estate and Inheritance Taxes
Estate taxes and inheritance taxes are different from capital gains taxes. They apply to the transfer of assets at death, not to a later sale.Federal estate tax
Federal estate tax
The federal estate tax applies only to estates exceeding the exemption amount. For 2024, the exemption is $13.61 million per individual. Estates below this threshold owe no federal estate tax. The exemption amount adjusts annually for inflation and is scheduled to decrease significantly in 2026.
State estate taxes
State estate taxes
Some states impose their own estate taxes with lower exemption thresholds than the federal level. Exemptions range from around $1 million to matching the federal amount, depending on the state.
State inheritance taxes
State inheritance taxes
A few states tax beneficiaries who receive inherited assets. The tax rate often depends on the beneficiary’s relationship to the deceased. Spouses are typically exempt, while distant relatives or non-relatives pay higher rates.
Maryland is the only state with both an estate tax and an inheritance tax.
Tax Implications by Decision
The tax consequences differ based on what heirs do with the property.Selling the property
Selling the property
Capital gains tax applies to appreciation above the stepped-up basis. Selling soon after inheritance typically results in minimal gain. Waiting allows more appreciation to accumulate, increasing potential tax liability.Selling costs (agent commissions, closing costs) add to the basis, reducing taxable gain.
Moving into the property
Moving into the property
No immediate tax consequences. If later sold as a primary residence after living there at least two of the previous five years, heirs may exclude up to $250,000 (single) or $500,000 (married filing jointly) of capital gains under the primary residence exclusion.
Converting to rental property
Converting to rental property
Rental income is taxable. Heirs can deduct operating expenses, property taxes, insurance, and depreciation. Depreciation reduces taxable income but also reduces basis, increasing capital gains when eventually sold.A 1031 exchange allows deferring capital gains by reinvesting sale proceeds into another investment property.
Depreciation Considerations for Rentals
If converting inherited property to a rental, depreciation deductions reduce taxable rental income each year. However, depreciation also reduces the property’s basis. How it works:- Residential rental property depreciates over 27.5 years
- Only the building value depreciates, not land
- Depreciation is calculated from the stepped-up basis at inheritance
Learn More
Tax Implications of Selling
Detailed guide on capital gains, exclusions, and timing strategies
Rental Property Taxes
Income, deductions, and depreciation for investment properties
1031 Exchanges
Deferring capital gains through like-kind exchanges
Accountants & Tax Overview
Types of tax professionals and when to hire them
Appraisers Overview
Understanding appraisals for stepped-up basis documentation
Types of Appraisals
Different appraisal types and when each is needed
Comparing Accountants
Finding tax professionals for inherited property situations
Property Tax Appeals
Challenging property tax assessments after inheritance
Next: Deciding What to Do
Framework for choosing between selling, keeping, or renting