What Taxes Do I Have to Pay When I Sell Inherited Property?

You received some stock or a house from Mom or Dad’s estate. There was no estate tax on the property at death because the estate was under $5.45 million (in 2016). You now want to sell the property. Although there may not be estate taxes, there may be other taxes you have to pay when the property is sold?

You have probably heard the quote from Benjamin Franklin, who in 1789 wrote: “in this world, nothing can be said to be certain, except death and taxes.” Franklin was actually paraphrasing Daniel Defoe from his 1726 book, The Political History of the Devil. I like Will Rogers’ take on it some two centuries later: “The only difference between death and taxes is that death doesn’t get worse every time Congress meets.”

What taxes you have to pay when you sell inherited property is going to depend on the type of property, how the property was owned before you received it, and the value of the property. If the stock you received from the estate was owned solely by Mom or Dad on their date of death, when you sell the stock, you would only have to pay long-term capital gains taxes on the increase in value from the date of death. Your tax basis in the stock would be the fair market value of the stock on the date of Mom or Dad’s death. This is called the step-up in tax basis rule.

Similarly with real estate. You would only have to pay long-term capital gains taxes if the property appreciated in value since the date of death. For example, let’s say you just sold Dad’s home, which you received after Dad died in 2010. Dad originally paid $10,000 for the home in the 1960s, but you sold it for $130,000. If the home was worth $115,000 on Dad’s date of death in 2010, your tax basis is $115,000.

When you sold it for $130,000 in 2016, you only have to pay long-term capital gains taxes on a gain of $15,000. You are taxed only on the increase from the date of death value of $115,000, to the sales price of $130,000. The $105,000 gain from Dad’s original purchase price of $10,000 to the date of death value of $115,000 completely escapes all income taxes. Great result.

With real estate however, there are additional taxes upon a sale. Whenever you sell real estate, there are county and state transfer taxes. These transfer taxes are effectively sales taxes on the sale of the real estate. These taxes are charged on the total sales price at a rate of $8.60 per thousand dollars of sale price, regardless of whether you have a tax gain or not. The transfer taxes on the $130,000 sale of Dad’s house in the example above would be 130 times $8.60, or $1,118.

What about property taxes? With Proposal A from 1994, your property tax increases are generally limited to the lesser of the rate of inflation or 5%. If the assessed value of your home, also called the State Equalized Value (SEV), goes higher than the Proposal A amount, your taxable value stays at the Proposal A amount. This is called “capping” your property taxes. If you have owned your home for decades, likely there will be a large difference between the taxable value and the SEV, sometimes even double or triple.

When you sell the home, the taxable value will jump up to the SEV. This is called uncapping. Most family transfers of real estate after a death, even through trusts, will not result in the uncapping of the property taxes until the real estate is sold outside the family.

What if Dad gifted the property to you in 2002, long before his death, by quit claim deed into your sole name, there would be a very different result. Your tax basis in the property would be the same as Dad’s basis in the home of $10,000. This is called carryover basis. When Dad’s home sold for $130,000 in 2016, you would then have pay long-term capital gains taxes on the entire $120,000 gain. Bad result.

There is a special rule for gifted property you sell for a loss. Your basis is the lesser of the carryover basis or the fair market value on the date of gift. This prevents Mom or Dad from transferring their tax loss to you by gift.

A situation in which the step-up in tax basis rules confuse many individuals and tax preparers alike is joint ownership. If Dad added you as a joint owner of his home and you never provided any funds for the purchase, improvement, maintenance or upkeep of the property, there is a different income tax treatment depending upon whether the home is sold before or after his death.

If that joint property is sold during Dad’s lifetime for say $100,000, you and Dad would each report $45,000, or one-half of the $90,000 long-term capital gain on the sale of the home using Dad’s original carryover basis of $10,000. There typically is no step-up in basis for these types of gifts when they are sold during the original owner’s lifetime. However Dad’s share of the gain would not be taxable to him if he owned and used the home as his principal residence for at least two of the last five years.

On the other hand, if the joint property was not sold until after Dad’s death, you would receive a full step-up in basis of that home to the value on Dad’s date of death. You are taxed only on the increase in value from Dad’s date of death to the date of sale.

If you as the surviving joint owner contributed to the purchase, improvement, maintenance or upkeep of the joint property, you would only get a partial step-up in tax basis as surviving joint owner. You would have to prorate the contributions of each joint owner in the property, and the step-up in tax basis would only be on that portion of the joint property contributed by the deceased.

The step-up in basis rule is a little different with joint ownership between a husband and a wife. For property that is held jointly by a husband and wife, each spouse is deemed to own one-half of the property, regardless of contribution. Upon the death of one spouse, the surviving spouse gets a step-up in tax basis in the half received from the deceased spouse and a carryover basis in his or her own half.

The step-up basis rule does not apply if you are a beneficiary of a deceased’s IRA, qualified retirement plan such as a 401(k) or 403(b) or other qualified account. The funds in these accounts are pre-tax and were never income taxed to the deceased. When you as a beneficiary pull funds out of these accounts, you will pay ordinary income taxes on the withdrawals just like the deceased would have. Depending upon how the accounts are set up, you may have to make withdrawal of the entire account or only a required minimum distribution.

You have options. With proper planning and consultation with a knowledgeable estate planning and tax specialist, you can minimize taxes, minimize expenses and maximize the amount available to your beneficiaries.

By Matthew M. Wallace, CPA, JD

Published edited November 13, 2016 in The Times Herald newspaper, Port Huron, Michigan as: What taxes do I have to pay when I sell inherited property?