If you inherit a home or property, do you qualify for the $250,000/$500,000 home sale tax exclusion that allows many home sellers to avoid paying capital gains tax? The short answer is no. However, you benefit from the stepped-up basis rules for inherited property. As a result, you might not need the exclusion when you sell the home. We'll get into the details below, including:
First a little background. U.S. tax law provides qualifying homeowners with a generous tax exclusion when they sell their property. Up to $250,000 of any gain from such a sale received by a single homeowner is tax free. For married homeowners filing jointly, up to $500,000 of gain is excluded from their gain.
To qualify for the exclusion, the home must have been used as a main home for two years out of the prior five years before the sale. For details, see The $250,000/$500,000 Home Sale Exclusion.
At the time you inherit a home, you won't qualify for this exclusion. You'd have to move into the home and live there for at least two years to qualify.
However, you might not really need the exclusion, because of the stepped-up basis rules, which can also reduce one's capital gains tax obligation.
"Basis" means an asset's cost for tax purposes. To determine whether you have a profit or loss when you sell an asset, you subtract its basis from the sale price. If you have a positive number, you have a gain. If you have a negative number, you have a loss.
The basis of a home you buy or build is its cost, plus any improvements you make while you own it. See Determining Your Home's Tax Basis for details.
However, a home's tax basis is determined in a different way when someone inherits a home after the owner dies. When you inherit property, you automatically receive a "stepped-up basis." This means that the home's cost for tax purposes is not what the now-deceased prior owner paid for it. Instead, its basis is its fair market value at the date of the prior owner's death. This will, given real estate's tendency to appreciate over time in the United States, usually be more than the prior owner's basis.
The bottom line is that if you inherit property and later sell it, you pay capital gains tax based only on the value of the property as of the date of death.
Example: Jean inherits a house from her father George. He paid $100,000 for it over 20 years ago. George made $20,000 in improvements over the years, so his tax basis in his home just before George died was $120,000. However, when Jean inherits the home its basis is stepped-up to its fair market value on the date of George's death. Jean has the home appraised and this value is set at $500,000. Jeans sells the house for $505,000 a few months after she inherits it. Her tax basis in the house is $500,000. She subtracts this amount from the sales price to determine her taxable gain: $505,000 sales price - $500,000 basis = $5,000 gain.
If you sell an inherited home for less than its stepped-up basis, you have a capital loss, which can be deducted (assuming you don't use the home as your personal residence). However, only $3,000 of such losses can be deducted against your ordinary income per year. Any excess must be carried over to future years to be deducted.
See IRS Publication 551, Basis of Assets, for more on the subject.