How to Avoid Capital Gains Tax When Selling Inherited Property: 7 Ways to Avoid or Minimize it

Inheriting a property can be both a financial gain and a challenge. While it may provide stability or extra income, selling it can come with unexpected tax burdens. Many heirs worry about capital gains tax on inherited property and how much they’ll owe if they decide to sell.

Here’s the deal: You may not have to pay as much in taxes as you think. In some cases, you might even avoid capital gains tax altogether. This guide explains your best options in simple terms.

Key Insights at a Glance

• Inherited property gets a step-up in basis, which can significantly lower taxable gains.
• Selling soon after inheriting often results in little to no capital gains tax.
• Living in the property for two years may qualify you for a tax exclusion.
• A 1031 exchange can defer taxes if you reinvest in another investment property.
• Deducting selling costs can help reduce your taxable gains.

Understanding Capital Gains Tax on Inherited Property

When you inherit a house, the IRS does not treat it the same as a property you buy. Instead of paying tax on the full value of the home, you only pay capital gains tax on the profit when you sell it.

Now, here’s the good news: The IRS applies a “step-up in basis” rule.

This means the home’s value is adjusted to its fair market value at the time you inherit it, not when the original owner bought it. If you sell it for a similar price, your taxable gain is low—or even zero.

Example of the Step-Up in Basis Rule

Let’s say your parents bought a home 30 years ago for $100,000. When you inherit it, the home is worth $300,000.

If you sell it soon after for $305,000, your taxable gain is only $5,000—not the $205,000 difference from the original purchase price.

This rule prevents heirs from paying taxes on home value increases that happened before they inherited the property.

But here’s the kicker: If the home’s value continues to rise after you inherit it, you could owe more in taxes the longer you wait to sell.

7 Ways to Avoid or Minimize Capital Gains Tax on Inherited Property

There are 7 ways you can avoid or reduce capital gains tax on an inherited property in several ways. You can sell it soon after inheriting it, live in it for at least two years to qualify for a tax exclusion, use a 1031 exchange to reinvest in another property, or deduct selling costs and improvements to lower your taxable gains.

1. Sell the Property Soon After Inheriting It

One of the simplest ways to avoid a large tax bill is to sell the property shortly after inheriting it.

Since capital gains tax is based on the difference between the sale price and the stepped-up value, selling early means you may owe little or no tax if the price hasn’t increased significantly.

If you wait several years, the property may appreciate in value, increasing your taxable gains when you sell.

2. Live in the Property to Qualify for a Tax Exclusion

You might be wondering: Can I avoid capital gains tax by living in the home?

Yes! If you move into the inherited property and make it your primary residence for at least two years, you may qualify for the primary residence exclusion.

This allows you to exclude up to:

• $250,000 in capital gains (single filers).
• $500,000 in capital gains (married filing jointly).

To qualify, you must have lived in the home for at least two of the last five years before selling it.

This strategy is ideal if you already plan to move into the home or need time to decide what to do with the property.

3. Use a 1031 Exchange to Defer Taxes

If you want to sell and reinvest the money in another property, a 1031 exchange allows you to defer capital gains taxes when you reinvest in a similar investment property.

Here’s how it works:

• You sell the inherited property.
• You use the proceeds to buy another investment property.
• The capital gains tax is deferred until you sell the new property.

But here’s the deal: Primary residences do not qualify for a 1031 exchange. This strategy is only for investment properties, so you’d need to convert the inherited home into a rental before using this option.

Also, strict deadlines apply—you must:

• Identify the replacement property within 45 days.
• Complete the purchase within 180 days.

4. Convert the Property Into a Rental Before Selling

This is crazy, but renting out the inherited home before selling it can lower your taxes in the long run.

When you rent the property, you can:

• Deduct maintenance costs, property taxes, and depreciation.
• Spread capital gains taxes over time, rather than paying them all at once.
• Benefit from lower long-term capital gains tax rates if you hold the property for over a year.

However, when you eventually sell, you may owe depreciation recapture tax, which taxes the depreciation you claimed over the years.

5. Disclaim the Inheritance If You Don’t Want the Property

If an inherited home comes with financial burdens like property taxes, maintenance, or debt, you can disclaim the inheritance, meaning you refuse to take ownership.

You might consider this if:

• You don’t want the responsibility of maintaining the property.
• You want to avoid potential capital gains tax on inheritance later.

However, disclaiming must be done within nine months, and once you disclaim, you cannot reverse the decision.

6. Deduct Selling Costs and Capital Improvements

Want to know the best part? You can reduce taxable gains by deducting certain expenses.

When selling an inherited home, you can deduct:

• Closing costs (real estate commissions, title fees, legal fees).
• Improvements that increase property value (new roof, remodeling).
• Marketing and staging expenses were used to sell the home.

For example, if you spend $15,000 remodeling the kitchen, that amount reduces your taxable gain when you sell.

7. Check State Tax Rules for Additional Exemptions

Capital gains tax isn’t just a federal issue—some states also have their own taxes on inherited property.

A few things to keep in mind:

• Some states, like Texas and Florida, have no state capital gains tax.
• Other states, like California and New York, tax capital gains as regular income.

If you inherit a home in a high-tax state, check if you qualify for any state-level exemptions or deductions. A tax professional can help you navigate specific state rules.

State taxes may apply, and these vary from state to state.

Always consult with tax professionals or financial advisors to receive personalized advice tailored to your specific circumstances.

FAQs About Capital Gains Tax on Inherited Property

In conclusion, the best way to reduce or avoid capital gains tax when selling inherited property depends on your financial goals. Selling quickly, living in the home, using a 1031 exchange, or deducting expenses can all help.

Need guidance? Big and Small Properties helps homeowners navigate real estate sales smoothly. Contact us today to explore your options and get the best deal on your inherited home!