Getting an inheritance of any kind is a financial blessing. But can it arrive with a small curse as well?
A Money Talks News reader named Ann asked that question:
“I’m selling a house inherited from my mother. What kind of tax implications am I facing? I live in Texas where there is no state income tax.”
OK, Ann, let’s discuss.
As we begin this discussion, keep in mind that we’re talking about income taxes, not estate taxes.
The beauty of an inheritance
When you inherit something, you don’t owe income tax. Gifts and inheritances aren’t considered taxable income.
But if you sell something you inherited, you could owe tax on the gain.
When you inherit things like real estate, odds are good it will be worth more than it was when the original owner bought it. In this case, for example, Ann inherited a house from her mother. Ann is concerned that when she sells her inherited house, she’ll have a big gain and a big income tax bill to go with it.
Thankfully, however, that’s not the case — at least not under current federal law.
When you inherit real estate, its original purchase price, known as its “basis” for tax purposes, is increased to the value as of the date of death. This is known as a “stepped-up” basis.
Example: Ann’s mom buys a house in 1970 for $100,000. When Ann’s mom passes away, the house is worth $500,000. For tax purposes, the cost, or basis, of the house is now “stepped up” to $500,000. If Ann sells it at that price, she has no taxable gain to report. If she sells it for less than that price, she may even have a taxable loss to report.
This rule is also true when you inherit things like stocks (except if they are in vehicles such as a 401(k) plan or IRA) or other things that have a cost basis. Stepped-up basis is why it’s typically better to inherit something than to get it as a gift.
Recently, the White House has proposed eliminating the stepped-up basis for people who inherit more than $1 million in capital assets, including real estate. But whether that actually happens is up to Congress, which has yet to act on it. So, unless Congress changes the current federal law, this is not a concern.
Receiving a gift
When you’re gifted an asset, the good news is that, as when you inherit, there’s no income tax due. The bad news, however, is that you don’t get to step up the basis as you do with inheritances.
When someone gives you something, your tax basis is the same as theirs. So if Ann’s mom had gifted her the house rather than leaving it to her, Ann’s tax basis would have been $100,000, the same as her mom’s. If she immediately sells the house for $500,000, her $400,000 profit would be taxed like all Ann’s other income. That means she could pay up to 37% of her gain in taxes. On a $400,000 gain, that’s $148,000.
What could Ann do in this case? Well, if she keeps her gift house for more than a year, she’d qualify for long-term capital gains treatment, meaning the profit would be taxed at a lower rate. If she kept the house for more than a year, the most she’d pay is 20%, or $80,000. So, keeping the house for a year would save her $68,000.
There is one last thing Ann could do to lower her taxes, and you might be able to do it as well when you sell your house. It’s called the home sale exclusion, or the capital gains exclusion for the sale of a home.
Here’s how it works: If you live in your home for at least two of the last five years, you don’t have to pay taxes on the first $250,000 of the gain if you’re single — or $500,000 if you’re married filing a joint return — providing you haven’t already claimed the exclusion during the past two years.
So think about this: Ann gets a house as a gift and decides to sell it. She could owe nearly $150,000 if she sells it right away, $68,000 if she waits a year, and potentially nothing at all if she moves in and waits two years.
And this, my friends, is why we always talk to a tax expert before we make major money moves!
Hope that answers your question, Ann.
I founded Money Talks News in 1991. I’m a CPA, and I’ve also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate.