Inheriting money or property can be a life-changing event. But along with the excitement comes the question of taxes. Will you owe taxes on your inheritance? The answer, in most cases, is no. You generally don’t need to report the inheritance itself on your income tax return. However, there are some exceptions and tax implications to consider when selling inherited property.
Taxation of Inherited Income
One exception to the general rule is if you inherit income that the decedent had earned but hadn’t received yet. This could include things like salary, bonuses, or pension payments. In this case, you would be taxed on this income just as the decedent would have been.
Capital Gains Tax and Inherited Property
The bigger concern for most inheritors is likely the capital gains tax they might face when selling inherited property. This is especially true for property that has increased significantly in value since the original purchase.
Fortunately, there’s a tax benefit for inherited property: stepped-up basis. This means the basis (the value used to calculate capital gains tax) for inherited property is generally increased to the fair market value on the date of the decedent’s death. Let’s say your parent bought a house for $100,000 years ago and it’s now worth $500,000 when they pass away. If you sell the house for $500,000, you wouldn’t owe capital gains tax because the basis is now $500,000, resulting in no gain.
Basis for Different Ownership Scenarios
Things can get a bit more complex when dealing with inherited property that wasn’t solely owned by the decedent. Here’s how basis is determined in different situations:
- Unmarried Joint Tenants: If you inherit property you jointly owned with the deceased as unmarried joint tenants, your basis is generally increased by the fair market value of the portion included in the decedent’s estate, added to your original basis in the property.
- Married Couples: For married couples, the surviving spouse’s basis in inherited property depends on whether the property was held as separate property or community property. Inherited separate property receives a basis equal to the fair market value at the deceased spouse’s date of death. For inherited community property, the surviving spouse’s basis becomes 100% of the fair market value at the date of death.
Selling Inherited Property at a Loss
In some cases, inherited property may have decreased in value since the decedent’s death. Losses on the sale of personal use property, like a primary residence, are typically not deductible for tax purposes. However, there is an exception for inherited property that is not your primary residence. If you inherit a house you don’t live in and sell it at a loss, you may be able to deduct that loss against your capital gains, up to a limit of $3,000 per year ($1,500 if married filing separately).
Importance of Proper Documentation
When inheriting property, it’s crucial to have a certified appraisal done to establish the fair market value on the date of death. This will be your basis for calculating capital gains or losses when you eventually sell the property. The appraisal is especially important if the IRS questions the value you used.
Conclusion
Inheriting property can be a wonderful thing, but it’s important to understand the potential tax implications. By familiarizing yourself with stepped-up basis and how it applies to different ownership scenarios, you can be better prepared to handle the sale of inherited property and maximize your tax benefits. If you have any questions about inheritances or property sales, consulting with a tax professional is always recommended.
