Minimizing taxes on inheritance
Buyer wants to know how to minimize taxes on a rental property he inherited.
Q: I inherited my mother’s home. That part went well, but boy was I uninformed. As I’ve now learned, and Ilyce’s site (ThinkGlink.com) made this clearer, when one inherits a house: (i) You can benefit by paying less taxes if the house was a principal residence, which it wasn’t in my case; and (ii) you can pay no taxes if the house is in a trust and you sell the home within a year of the death of the owner.
In my case, my mother died in August of 2020 and the trust deeded it to me in September of 2021. I then sold it July 2022 since a family was renting it from the trust until June of 2022. Is there any way we can minimize the taxes I’ll have to pay on the sale of the house I inherited?
Minimizing taxes on a house you inherit
A: Before we answer your question, we want to clarify a couple of things. The first item is that you should know that if you live in a property as your primary residence for two out of the last five years, when you sell that home, you can exclude from federal taxes up to $250,000 in profits if you are single and up to $500,000 in profits if you are married.
This home sale exclusion would apply to your mother if she sold her home while she was alive. And it would also apply to you, if you inherited the home, then moved in and used it as your primary residence for two out of the last five years.
Stepped-up basis will help minimize taxes on inheritance
Now, let’s talk about what happens to the value of a home when you die for Internal Revenue Service purposes (IRS). Let’s say your mom purchased her home for $250,000 and died when the property was worth $500,000. The IRS allows you to step up the basis of the home when she dies. This means that you inherit the home at the home’s value at the time of her death or $500,000.
If you sell the home within a year of her death, the IRS would consider the sales price at the time of the sale to be what the home was worth when she died, meaning that you would have no taxes to pay the IRS for the sale of the home. This rule applies whether the home was owned in someone’s name or in the name of a living trust. The living trust simply makes it much easier to transfer ownership of a home after the death of the owner. (We much prefer that you place your home in a living trust rather than add your children to the home’s title.)
Sell inherited home within a year to minimize taxes
The heirs get a great deal. They inherit a home that may have appreciated in value considerably but can ignore what the owner may have paid and what was done to the property over the years. In simpler terms, when someone dies and gives you a home and you then sell shortly after they die (within a year), you would have no taxes to pay on the sale of the home to the IRS. You can get more information from Publication 523 from the IRS website.
Now back to your question. Your mom died in 2020. At the time of her death, the home was in a living trust and presumably your mom was both the trustee and owner of the trust. When she died, you then became the successor trustee and successor owner of the trust. (This is the case in most instances.) You could have transferred the home into your name at any time after your mom died.
Inherited home value pegged to day of death – but IRS recognizes that for a year
The important thing is that when your mom died, you inherited the home at the home’s value when she died. Say the home was worth $500,000 when she died. You then transferred the home into your name in 2021 and then sold the home in 2022. So the most important thing here is what the home was worth when she died (in our example, $500,000) and what you got for the home when you sold it.
Let’s assume when you inherited the home it was worth $500,000. Then, two years later, you sold it for $550,000 or about $50,000 in profit. But you paid a sales commission to the real estate agent and had other closing costs.
Subtract costs of sale from sales price to further minimize taxes
You might have also had to do work to the home to get it ready for sale, like painting it or staging it. Some of those expenses might help reduce the profit on the sale of the home. And, if the commission was five percent ($25,000 on the sales price) and you had closing costs of $10,000, your true profit would be around $15,000.
You’ll have to review your actual numbers to see what your profit was. But if the home hadn’t increased in value from the time your mom died, you likely wouldn’t owe much in taxes. One wrinkle is the fact that the property was rented for two years after you inherited it. That could wind up helping you. Without going into the details, you held the home for investment purposes and will pay long term capital gains on any profit you made by holding onto the home. You will also have to recapture any depreciation you took in that time.
At most, we see you paying 23.8% (20% maximum capital gains tax plus the 3.8% net income tax) in federal taxes plus any state income taxes you might owe. You should talk with a tax professional (CPA, enrolled agent or tax attorney) to make sure you get the benefit of all allowable deductions and expenses that can reduce any profit generated by the home sale.
You can get more information on these items and examples from IRS Publication 523. Thanks for your question.
Leave A Comment