When you buy real estate, your purchase price becomes what the Internal Revenue Service calls your basis. When you sell, your capital gain or loss is the difference between the basis and the sale price, plus some adjustments. The rules are different for selling inherited property, as you don't have a purchase price. Depending on the circumstances, you may have a deductible loss from the sale.
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Inherited Property Basis
Your basis in inherited property is the fair market value the day the previous owner died. For example, suppose your father bought his home for $150,000, but it was worth $250,000 on the day he died. The second figure is your basis: If you sell for $200,000, you have a $50,000 loss rather than a $50,000 gain.
Normally, you classify gains and losses as short term or long term, depending how long you've held the property. But with an inherited property, you always classify the gain or loss as long term.
The basis will be either the property's fair market value when the person died, or if an estate return was filed, it can be the FMV on another date the valuation occurred. In cases where the decedent died in 2010, the basis can be calculated one of these two ways according to IRS Publication 4895: the smaller amount of either 1) the adjusted basis of the decedent, or 2) the FMV calculated at the time of death.
Use of Property
You can deduct losses on the sale of investment property but never on personal property. For example, if you inherit a business or rental property and then sell it, you may be able to deduct a capital loss. You can also deduct a loss on a residential property if you inherit it but never made personal use of it. If, after inheriting, you and your family moved into the home and lived there, you don't get to write off any losses when you sell.
Deducting a Loss
You report capital gains and losses on IRS Schedule D and attach it to your 1040. If you have a deductible loss on the sale of inherited property, you add it to your other long-term gains and losses for the year. You add that result to your total short-term gain or loss.
If the final result on Schedule D is a loss, you can write off up to $3,000 of red ink against your non-capital gains income. For married couples filing separately, the write-off is only $1,500.
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Carrying Over Losses
Suppose you sell an inherited property at a $10,000 loss and have no other capital sales. After you deduct $3,000 against your regular income, you have to carry the rest of the loss forward to next year. You can deduct $3,000 over and over until the loss is used up. If you have capital losses in future years, you use them up first.
For example, suppose you carry forward $7,000 and have a $1,000 capital loss next year. You can also write off $2,000 of the carried amount. The remaining $5,000 goes forward another year. IRS Publication 544 has the details on calculating carry overs.