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Whether you’re planning ahead for your heirs or have recently inherited property yourself, it can be confusing and stressful to determine whether or how much taxes on your inherited home could be. Being aware of the differences between capital gains tax, estate taxes, and other fees or tax on inherited property could be beneficial after the owner’s death. Knowing the tax rules and any other cost associated with the property could make an impact on how much profit heirs could make if they decide on selling the inherited property.
Inheritance Tax vs. Estate Tax
Many people refer colloquially to estate tax as a “death tax” and use the term interchangeably with inheritance tax. However, legally-speaking, they’re two different things. The primary difference is what the tax is on – either the transfer of the property, or the identity of the person inheriting property.
There is no inheritance tax at the federal level, so the only reason this tax would be levied is if the person inheriting the property is in one of the six states that charge inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. In North Carolina, there is no state tax on inherited property, so even if someone lives in one of the six states that levy this tax, they would not owe inheritance tax on a property in North Carolina. However, if you live in North Carolina and inherit property in one of these six, you could owe an inheritance tax.
The other factor with these taxes is the relationship of the person about to inherit real estate to the decedent. Spouses do not have to pay inheritance tax, even if the property is in one of the states above. Children and grandchildren only owe if the inherited house is in Nebraska or Pennsylvania. All others would be required to pay inheritance tax under the limited scenarios discussed above.
Again, North Carolina doesn’t require these taxes, so if the heir and the property are both in this state, inheritance taxes won’t apply.
Whereas the inheritance taxes are applied to the inherited property after it passes to the heir, estate tax is levied on the property first, before it changes ownership. There is a federal estate tax, but North Carolina does not have any additional taxes on estate.
Even with the federal taxes, most average heirs wouldn’t ever have to be concerned about owing this tax. In 2022, the federal exemption for estate taxes is $12.06 million, so if the inherited home is worth less than that amount, you wouldn’t expect to owe taxes on it.
If the inherited home is more than the federal exemption, the tax only applies, at varying rates, to the amount of value over that federal minimum. For example, if the estate is worth 12.56 million, you’d owe taxes on only the extra $500,000.
If you’re a resident of North Carolina, and you inherit a property in North Carolina, it’s relatively unlikely that you’ll pay either estate or inheritance taxes. If the property is out of state or worth more than the federal exemption amount, it’s possible some taxes might occur.
Selling the Home: Capital Gains Tax
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Another concern some heirs might have in terms of personal finance, is whether or not capital gains taxes might apply to the inherited property. This is only a concern if the heir intends to sell the asset, rather than living in it. Capital gains tax liability refers to the taxable gain on the inherited property, i.e. the difference between the current market value and the original cost basis, or what the asset was worth when it was purchased, or when it came into your possession.
Tax basis for capital gains taxes
Any asset would have a tax basis, often simply “basis”, or the value of the assets at the original sale. Whether the original owner purchased the house years ago or shortly before the decedent’s death, the most recent sale is considered the original purchase price for tax purposes. This original cost basis, however, may not be the amount used when the heir wishes to sell the inherited real estate.
Stepped up basis
If you inherit a home, the tax basis is usually not the original sales price, but is instead the fair market value at the time of the decedent’s death. This valuation is known as the “stepped up basis”, because the basis has been “stepped up” from the sale to the date of death.
In the case of most inherited property, then, capital gains tax is only owed on the difference between the market value at the date of death and the current value when you sell the property.
Alternate valuation date
If the house needs many improvements before sale, that are likely to increase the sales price significantly, or if the real estate market value is subject to regular increases, heirs may wish to appeal for an alternate valuation date. This could decrease the taxable income when you sell the home, because the stepped-up basis is considered to be six months from the owner’s death, rather than the day of.
This can be beneficial in some circumstances, because the higher the stepped up basis, the closer to the current selling cost of the house at fair market value, the less likely you are to pay capital gains tax. If you don’t want to pay capital gains taxes, or at least want to reduce capital gains taxes, this could be an option to help.
Will I pay capital gains tax?
If you inherit a property and sell it immediately, you likely won’t owe any capital gains tax, because the stepped up cost basis and the price of the house at the moment of sale would be the same or very similar.
If there is a difference between the cost of the house at the time you inherit and the time of the sale, because you made expensive improvements, because you used it as an investment property for a few years, or for some other reason you may wind up paying capital gains taxes.
It may be useful to know, however, that you wouldn’t pay taxes on the entire sale of the house, but only on the capital gain. For example, if you inherit a house worth $250,000 and sell it later for $300,000, you will likely only owe capital gains on the $50,000 difference.
Keeping the Home
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It may be that you aren’t planning to sell the home, or at least want to keep it for a while. You have several options when it comes to keeping inherited real estate. Whether you can’t bear to part with the property, don’t want to go through the hassle of selling, or have been wanting to create a source of passive income, you may wish to keep the home.
Living in the inherited property yourself
If, rather than immediately disposing of the property, you decide to make it your primary residence, you may be able to avoid capital gains. If you live in a property for at least two years prior to selling, you may be eligible to claim a Section 121 exclusion, meaning you could exclude up to $250,000 (or $500,000 on joint returns) of capital gains.
Renting out the home
Because capital gains are not taxed until a property is sold, it may be beneficial to some to use the real estate as an investment property. There are, of course, other costs associated with owning a home, including property taxes and insurance policies, but if the money you accumulate from renting the home is enough, it could be worth it.
Staying vs. paying
No matter the reason you intend to keep an inherited property, it’s possible that maintaining the house is a better choice than selling it immediately. It’s generally wise to consider whether or not you’ll subject yourself to more from being taxed than it would be worth over the course of ownership.
Checking in with the Experts
As with any large financial decision, figuring out what to do with an inherited property may require you to consult professionals with expertise in the matter. This could be especially important in the case of a decision that might involve grief and family in ways that differ from other real estate transactions.
Often, inheriting assets of any kind will require the assistance of a lawyer at some point during the process. Some may find this prospect intimidating, but developing a good attorney-client relationship with a lawyer from a reputable law firm can take a great deal of weight off the heirs.
Consulting with someone who knows the laws and tax rules around inheritance could make the difference between succumbing to overwhelm or making costly mistakes. Gaining assurance that the decisions you make are founded not only in sound financial planning but are also above-board in a legal sense can bring peace of mind during a trying time.
Likewise, regardless of which assets you inherit – property or other assets – working with a tax professional could help you avoid penalties or costly mistakes. Checking in with someone well versed in tax laws may be the key to making difficult decisions as simple as possible, under the circumstances.
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For many people, when they’re negotiating an inheritance, they’re also wrestling with the death of someone they cared about. There’s nothing that will make loss easy, but knowing more about your rights and obligations could help to assuage some of the confusion or fear that can accompany large decisions like selling inherited property.