Taxation of Inherited Property
Date of Death Value
Alternate Valuation Date
Gain or Loss on Sale
Deducting Loss on Sale of Inherited Home
If you are the recent beneficiary of an inheritance, you may be wondering if you will need to pay tax on the cash, stocks or real property that you received. Generally, the answer is no, and you don’t even need to report the receipt of the inheritance on your income tax return. But there is an exception: if you receive untaxed income that a decedent had earned or had a right to receive during their lifetime, you’ll be taxed on it just as the decedent would have been. Examples of this type of income are payments of compensation, wages, bonuses, commissions, vacation and sick pay that the decedent had earned but hadn’t received before they died; uncollected rent; installment payments from property sold before the decedent’s death; and most frequently, traditional IRA distributions.
Another situation you may be concerned about is what happens if you sell the inherited property, particularly if it had been the decedent’s personal residence. After all, the property may have been purchased years ago at a low cost by the deceased person but may now have vastly appreciated in value. The usual question is: “Won’t the taxes at sale be horrendous?”
You may be pleasantly surprised by the answer—special rules apply to figure the tax on the sale of any inherited property. Instead of having to start with the decedent’s original purchase price to determine gain or loss, the law allows taxpayers to use the value at the date of the decedent’s death (the inherited basis) as a starting point. This is commonly termed a “stepped up” basis, but it would be a “stepped down” basis if the value at the date of death is less than the decedent’s basis.
Sometimes the executor of the decedent’s estate can elect to use the value at an alternate date (usually 6 months after the date of death) but this is rare, as it can only be used to lower the estate tax. Currently, the value of the decedent’s entire estate would need to exceed nearly $13 million ($26 million if married) before estate tax might be owed. About 6,200 estate tax returns were filed in 2021, and of those only around 2,500 had a tax liability. So, the chance that the alternate valuation date method will apply is very low, and the date of death value will be used in nearly all cases.
Determining basis gets a little tricky when the decedent wasn’t the sole owner of the property. For example, in the case of unmarried joint tenants, when the first joint tenant dies, the presumption is that the entire value of a joint tenancy asset is included in the decedent’s estate. However, this is not the case if the surviving joint tenant can prove what amount he or she contributed toward purchasing the property. Then the surviving joint tenant’s basis is only increased by an amount equal to the amount included in the decedent’s estate (even when no estate tax return was required to be filed). The surviving tenant’s original basis (reduced for business or rental property by any depreciation or depletion claimed by the surviving joint tenant) is added to the value of the property that was included in the decedent’s estate.
For married taxpayers, where a property is held as separate property by one of the spouses and inherited by the other spouse, the basis in the hands of the inheriting spouse will be fair market value of the entire property at the deceased spouse’s date of death. Where a property is jointly owned (not community property) by both spouses and one spouse passes away, the surviving spouse already owns 50% and only inherits the deceased spouse’s 50%. Thus, the surviving spouse’s basis in the inherited portion will be 50% of the property’s fair market value when the deceased spouse died plus 50% of the joint basis.
If married taxpayers reside in a community property state and hold the property as community property, when one of the spouses dies, the surviving spouse’s basis becomes 100% of the fair market value at the deceased spouse’s date of death. For inherited community property used in business or a rental, no adjustment is required for prior depreciation claimed, and the depreciation of the inherited basis begins anew.
Often the selling price and the date of death value of the property are practically identical, and there is little, if any, gain to report. If there is gain, it receives long-term capital gain treatment, regardless of how long the decedent owned the property or how long the beneficiary retains the property before it is sold. The advantage here is that long-term capital gains are taxed at rates of 0%, 15% or 20%, depending on the individual’s adjusted gross income and if lower than their regular rate.
The sale of inherited property may result in a loss, particularly when it comes to real property such as the decedent’s personal residence on which large selling expenses (realtor commissions, etc.) must be paid.
Thus, it is important to have a certified appraisal of the home or other real property to establish the home’s tax basis on the date of death. If an estate tax return or probate is required, a certified appraisal should be completed as part of those processes. Otherwise, one must be obtained to establish the basis. It is generally not acceptable just to refer to a real estate agent’s estimation of value or comparable sale prices if the IRS questions the date of death value. The few hundred dollars it may cost for a certified appraisal will be worth it if the IRS asks for proof of the basis.
While the sale at a loss of inherited stock is unquestionably allowed (within the limits noted at the end of this paragraph), is a loss on an inherited home deductible? Normally, losses on the sale of personal use property, including one’s home, are not deductible. However, unless the beneficiary is living in the home, the home becomes investment property in the hands of the beneficiary, and a loss is deductible but subject to a $3,000 ($1,500 if married and filing separately) per year limitation for all capital losses with any unused losses carried forward to a future year.
In some cases, courts have allowed deductions for losses on an inherited home if the beneficiary also lives in the home. In order to deduct such a loss, a beneficiary must try to sell or rent the property immediately following the decedent’s death. In one case, where a beneficiary was also living in the house with the decedent at the time of death, loss on a sale was still deductible, when the heir moved out of the home within a “reasonable time” and immediately attempted to sell or rent it.
If the home is sold by the decedent’s estate (or trust, if applicable), rather than title passing to the beneficiary who then sells the property, the transaction will be reported on the estate’s (or trust’s) income tax return, and if there is a loss on the sale, that loss will be used to offset other income of the estate (or trust), with any excess loss passed through to the beneficiary on a Form 1041 Schedule K-1, generally in the final year of the estate (or trust). In this situation, the executor (or trustee) will be responsible for making sure the appropriate basis has been used in computing the gain or loss.
If you have questions related to inheritances or home sales, please give this office a call.