How to Handle Capital Gains on Inherited Property

30 May 2025

Inheriting property can be both a blessing and a headache. On one hand, it’s a valuable asset that could provide financial security. On the other hand, the tax implications—especially capital gains tax—can be overwhelming if you’re not prepared.

But don’t worry! In this guide, we’ll break down everything you need to know about how to handle capital gains on inherited property so you can keep more money in your pocket and avoid unnecessary tax burdens. Let’s dive in!

What Are Capital Gains on Inherited Property?

When you inherit a property, the IRS doesn’t just let you take ownership tax-free. If you decide to sell it, you may have to pay capital gains tax on the profit you make.

But here’s the good news—thanks to something called the stepped-up basis, you’re not taxed on the entire value of the property from when it was originally purchased. Instead, your tax liability is based on the property's fair market value at the time of the original owner’s passing.

What Is a Stepped-Up Basis?

Let’s say your parents bought a house decades ago for $100,000, and today it’s worth $500,000. Normally, if they sold it before passing, they’d owe capital gains tax on the $400,000 appreciation.

However, when you inherit it, your cost basis is “stepped up” to the current market value ($500,000). If you sell it immediately for $500,000, you wouldn’t owe any capital gains tax.

Pretty sweet, right? But the longer you hold onto the property after inheriting it, the more likely you’ll have capital gains to deal with.

How Capital Gains Are Calculated on Inherited Property

Capital gains are calculated based on:

1. Stepped-up basis: The home’s fair market value at the time of inheritance.
2. Sale price: How much you sell the property for.
3. Capital gains: The difference between the sale price and the stepped-up basis.

Example Calculation

Imagine you inherited a house worth $400,000. A few years later, you sell it for $500,000. The capital gain in this case is:

$500,000 (sale price) - $400,000 (stepped-up basis) = $100,000 capital gain

This $100,000 is what could be subject to capital gains tax unless you find ways to minimize it (which we’ll discuss soon).

How to Reduce or Avoid Capital Gains Tax

Nobody likes paying taxes, but fortunately, there are some smart ways to reduce or even avoid capital gains tax on inherited property.

1. Sell the Property Quickly

If you sell the inherited property soon after receiving it, there’s a good chance there won’t be much appreciation. Since capital gains are based on the difference between the sale price and the stepped-up basis, a quick sale can minimize your tax burden.

2. Make It Your Primary Residence

Did you know that if you live in the inherited home for at least two years, you may qualify for the primary residence exclusion?

This IRS rule allows:
- Single filers to exclude up to $250,000 in capital gains.
- Married couples filing jointly to exclude up to $500,000 in capital gains.

So, if you move in and live there for a couple of years before selling, you could potentially owe zero capital gains tax!

3. Use a 1031 Exchange

A 1031 exchange allows you to defer capital gains tax by reinvesting the proceeds from the sale into another investment property.

There are strict rules on timing and the types of properties you can exchange, but if you plan to reinvest, this could be a great strategy to defer taxes.

4. Offset Gains with Tax Losses

If you have other investments that are performing poorly, you can use capital losses to offset your gains. This is called tax-loss harvesting and is an excellent way to lower your taxable income.

5. Gift the Property Instead of Selling

Another strategy to avoid capital gains tax is gifting the property to a family member or charity. Keep in mind that gifting has its own tax implications, but in some cases, it might be more beneficial than selling outright.

Short-Term vs. Long-Term Capital Gains Tax

Most inherited properties automatically qualify for long-term capital gains tax rates, which range from 0% to 20% depending on your income.

Here’s a quick breakdown for 2024:

| Tax Rate | Single Filers (Income) | Married Filers (Income) |
|----------|----------------------|----------------------|
| 0% | Up to $44,625 | Up to $89,250 |
| 15% | $44,626 – $492,300 | $89,251 – $553,850 |
| 20% | Over $492,300 | Over $553,850 |

If you were to flip the inherited property for a quick sale after doing major renovations, you could trigger short-term capital gains, which are taxed as ordinary income (often a much higher tax rate).

State Taxes and Other Considerations

Federal taxes aren’t the only thing to worry about. Some states also impose capital gains taxes, so check your local laws.

Additionally, if the estate was large enough to be subject to estate tax, that could impact your overall tax situation.

Should You Sell, Rent, or Keep an Inherited Property?

Now that you know the tax implications, what should you do with the inherited property?

Option 1: Sell It

- Best if you need cash quickly.
- Avoids property maintenance costs.
- May trigger capital gains tax but can be minimized with smart strategies.

Option 2: Rent It Out

- Creates a passive income stream.
- Property continues to appreciate in value.
- You’ll have to manage tenants (or hire a property manager).

Option 3: Move In

- Qualify for the primary residence exclusion if you live there for 2+ years.
- No need to worry about capital gains taxes when selling later.
- Emotional attachment may make it the preferred choice for some families.

Your decision should depend on your financial goals and personal circumstances.

Final Thoughts

Handling capital gains on inherited property doesn’t have to be a stressful process. By understanding how capital gains taxes work, taking advantage of tax-saving strategies, and making informed decisions, you can maximize your inheritance while minimizing the tax bite.

Whether you choose to sell, rent, or move in, planning ahead will ensure you make the most of your newfound asset. And remember—when in doubt, consulting a tax professional can save you thousands in unnecessary taxes!