How Can We Avoid Capital Gains Tax on a House We’re Inheriting?

My spouse will inherit her father’s house outright upon death and wants to sell it immediately. Would she be subjected to capital gains tax (above the $250,000 exclusion) on the sale and would it matter if only she is on the deed? Or would it make sense to have both of us on the deed to get the $500,000 exclusion for filing jointly?

– Kenneth

The short and simple answer is that you likely will not owe any capital gains tax when you sell the property that your wife is inheriting from her dad. However, it doesn’t really have anything to do with the capital gains exclusion you mention or whether you are both on the deed. A tax provision known as the “stepped-up basis” is what will help you potentially avoid capital gains tax.

I think this situation presents an interesting discussion. Let’s see what’s at play here. (And if you have similar questions or others related to financial planning and investing, consider connecting with a financial advisor.)

Capital Gains Exclusion on Property Sales

You are correct that the IRS lets individuals exclude up to $250,00 in profits from the sale of a primary residence from taxes. Married couples filing their taxes jointly can exclude up to $500,000. In other words, you can “make” that much money on the sale of your home without getting a tax bill.

For a simplified example, let’s say a couple buys a house for $500,000. They can sell it for up to $1 million without owing anything on that gain. If their capital gains exceed $500,000, they would owe taxes on the excess profit. This example is very simplified because it assumes the purchase price is the couple’s exact cost basis and ignores transaction costs like real estate agent fees that can reduce the gain.

However, this exemption doesn’t apply to all property sales. In order to qualify for the exemption:

• The home must be the person or couple’s primary residence for at least 24 of the previous 60 months

• They must have owned the home for at least two years.

Whether or not both people in the couple are on the deed is irrelevant. In fact, only one of them has to satisfy the requirements listed above. Your tax filing status determines whether the $250,000 or $500,000 exclusion applies. Again, single filers get the $250,000 exemption, while married couples filing jointly receive the $500,000 exclusion. (And if you need help with similar tax planning scenarios, consider speaking with a fiduciary financial advisor.)

Stepped-up Basis on Inherited Property

If you sell the property immediately, you obviously won’t qualify for the capital gain exclusion described above. You’ll be fully on the hook for the tax liability on any gains you make when you sell the property.

Story continues

However, your gain will likely be $0 or very close to it, regardless of the price you sell it for. Let me explain why.

From a tax standpoint, the gain is the amount of money you make above the property’s cost basis. As mentioned above, the cost basis is roughly the price you pay for something. But there’s a major caveat for inherited property.

When you inherit a property, your cost basis is “stepped-up” to the property’s fair market value at the time you inherit it. Generally, this is the property’s value on the date of death. If you sell the property immediately (before the property’s value increases), the sale price will not be any higher than the cost basis. As a result, the sale would not produce any capital gains and your tax liability would be $0.

(If you need assistance calculating your tax liability or making strategic decisions for tax purposes, consider working with a financial advisor with tax expertise.)

Next Steps

To understand how the two rules work, picture this equation:

Selling price – Cost Basis = Gain

• You owe taxes on every dollar of gain you receive on the sale of an inherited property, but the step up in basis alters the equation by bringing your cost basis in line with the property’s fair market value.

Since your wife is inheriting the property, the second bullet applies. If you sell that property immediately, your selling price and cost basis are likely to be very close and result in little to no gain at all.

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Brandon Renfro, CFP®, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.

Please note that Brandon is not an employee of SmartAsset and is not a participant in SmartAsset AMP. He has been compensated for this article. Some reader-submitted questions are edited for clarity or brevity.

Photo credit: ©iStock.com/gorodenkoff, ©iStock.com/LaylaBird

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