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Tax Considerations of Inherited Property Sales

It is almost impossible for inherited property to qualify for the $250,000/$500,000 tax exclusion. However, with careful planning, sellers can take advantage of other tax loopholes and save thousands of dollars.

IRS rules reduce the reportable capital gain from real estate transactions by $250,000 for individuals or $500,000 for married couples filing a joint return. To claim this exemption, the seller must have lived in the house for at least two of the five years preceding the sale. The Service determines residence based on both objective factors, such as the address listed on a drivers’ license and other official documents, and subjective factors, including the home’s proximity to the seller’s workplace and other family members.

Many times, especially in the case of local inheritors, the owner partially meets this test, and it may be a good idea to live in the house for a brief time to reach the two-year mark. Bear in mind that the IRS will scrutinize this deduction and resolve any discrepancies or ambiguities in its own favor, so it is always best to consult a tax professional.

Other Tax Breaks

If the tax exclusion is out of reach, for whatever reason, the procedures for determining tax basis often come into play, because the IRS calculates basis (the house’s value for tax purposes) differently for inherited property. Traditionally, basis is the house’s construction cost plus the value of any improvements. But if the new owner(s) inherited the property, basis is the house’s fair market value at the time of sale.

Assume that Benjamin Buyer bought a house for $150,000 in 1976 and made an additional $50,000 in improvements over the years, perhaps by finishing the basement and adding a room. As a result, the house is worth $500,000. If Benjamin sells the house for that amount, he must report a $50,000 capital gain (because he qualifies for the $250,000 exemption). However, if Benjamin dies and leaves the house to Betty Beneficiary, she had no capital gain, since the sales price matched the fair market value.

If Betty sells the house at a loss, which often happens in these cases, she can claim up to a $3,000 capital loss in the current filing year; any additional loss must be carried over to future years.

Other Options

For emotional as well as financial reasons, renting the house may be an attractive alternative. Such an arrangement leaves the house in the family and provides additional options further down the road. The house (but not the land) is a depreciable asset, and this deduction often makes the rental income essentially tax-free.

There are some important considerations. For example, the homeowner’s insurance policy must be changed to a landlord policy and, if the house is sold later, the depreciation must be reported as a capital gain.

To sell inherited property faster, and keep more money with the estate, contact us today.

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