The Internal Revenue Service taxes almost anything of monetary value when it changes hands, but inheritances are often an exception. You can inherit cash without paying income tax on it. In most cases, if you inherit property and simply use and enjoy it, and your state has no inheritance tax, you shouldn't owe tax on this, either. When you sell an inheritance, however, you may owe capital gains tax to the IRS.
Calculating Capital Gains -- or Losses
A capital gain -- or loss -- isn’t too difficult to calculate. Normally, you would start with what you paid for an asset, then add on any money you put into capital improvements. The resulting number is your basis. When you sell the property, simply subtract your basis from the proceeds. The difference is your capital gain. If the balance is a negative number, you have a capital loss.
The Stepped-Up Basis for Inheritances
When you inherit an asset, your basis begins with the value of the property as of the date of death -- not what the deceased paid for it. This is called a stepped-up basis because it’s usually more advantageous tax-wise. For example, you might inherit stocks worth $100,000 as of the date of death and sell the asset a year later for $125,000. You have a $25,000 capital gain regardless of what the deceased initially spent to purchase the stock. If he paid only $25,000, the stepped-up basis prevents you from having a $100,000 capital gain instead.
The Stepped-Up Calculation for Co-Owned Property
When two people co-own an asset and one dies so that the other inherits the property, the rules are more complicated. Only half the basis is stepped up when the survivor sells. Her basis in her half of the property remains at half the original basis, but her partner’s half is valued as of his date of death. Suppose the two purchased real estate together for $100,000 and its value as of the date of death is $300,000. The survivor has only a $100,000 capital gain if she sells the property for $300,000. That's because her basis is $200,000 -- her half of the purchase price, or $50,000, plus half the date-of-death value, or $150,000. Without this partially stepped-up basis, her gain would have been $200,000 -- the difference between the initial purchase price and the sales price.
The Executor's Option
When it comes to tax law, things aren’t always as simple as they sound on the surface. When determining date-of-death value for capital gains purposes, the IRS uses the valuation determined by the executor when settling the estate. In some cases, the executor might choose a date other than the date of death for valuing a decedent’s property. This usually only happens if the estate is large and complex enough that it owes a federal estate tax. As of 2015, the estate’s value after subtracting its expenses and debts would have to exceed $5.43 million before it would owe an estate tax on the balance. The figure goes up yearly as it’s adjusted for inflation. This option can work in the beneficiary’s favor because the date is moved forward -- not back -- by six months. The asset might appreciate in value during this time, which would result in a higher basis and less capital gains on a sale.
The Home Sale Exclusion
You may have one other option to avoid or reduce capital gains on inherited property, but it only works with real estate. You’d have to retain ownership of the property for five years and reside in it for two years, after which you’d qualify for the capital gains home sale exclusion. Up to $250,000 in profit escapes capital gains tax with this exclusion if you’re single, or $500,000 if you’re married and you and your spouse file a joint tax return.