Inherited Property Tax Treatment

June 16, 2023 Published by

It can be difficult to plan for and navigate the changing legal landscape when you are deciding how to pass on a property or other assets to your family. There are many different federal and state tax laws for you to consider when you write a will. Luckily, there are many incentives at the federal and state level that you can take advantage of. If you inherit a property and want to sell it later, many tax incentives like a 1031 exchange or other incentives allow you to minimize or reduce your total capital gains taxes. Being knowledgeable of these incentives beforehand can make the planning process simpler.

Federal Tax Exemption

Based on current laws, most people will not have to pay a federal tax on any property they inherit, as the inherited property’s value needs to exceed $12.92 million before it is taxed. This number is adjusted every year based on inflation.

Therefore, if you inherit a property from anyone, and the property value is below this amount, you do not need to worry about paying capital gains taxes at the federal level. In most cases, it can be most strategic for you to hold onto the property after you inherit it, rather than selling it, to avoid an immediate capital gains tax. If you do this, there are other tax incentives you can take advantage of later if you decide to continue living in the home.

States that Have an Inherited Property Tax

Only six states in the United States have a state inheritance tax. These six states include Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. There are some exceptions that allow you to avoid paying state taxes, and these laws can change, so it is best to monitor these changes before planning around this.

This rule is based on where the benefactor lived, not where you live. Therefore, if you live in one of these six states and inherit property from someone who lives in another state, you do not have to worry about state inheritance taxes.

Most exceptions are for the deceased person’s spouse or other family members, such as siblings. If you are not related to the person you inherit the property from, you may be less likely to receive an exemption from paying state taxes.

The state tax range for each of these states will be between the following amounts if you have to pay it:

  • New Jersey: 0-16%
  • Pennsylvania: 0-15%
  • Iowa: 0-15%
  • Maryland: 0-10%
  • Kentucky: 0-16%
  • Nebraska: 1-18%

Annual Gift Exemption

If you know in advance that you want to leave a family member an inheritance, it can be strategic for you to slowly give them money every year rather than giving them one lump sum payment when you are older or when you pass away. You can give someone a $17,000 tax-free gift every year, and married couples can give away $34,000/per year. The amount you can donate every year has been steadily increasing and may increase in the future based on inflation. For example, the maximum tax-free gift in 2010 was only $10,000.

If you Sell the property

If you decide to sell an inherited property, any gain on the sale is taxable. You also need to claim this on your taxes on your 1040 form and Form 8949. In most cases, it is best to avoid selling the house after, especially if you anticipate that the house will appreciate after you sell it. However, you can deduct other costs like closing costs to offset the total capital gains that you end up paying.

The step-up basis is a term for what happens when you inherit a house that has appreciated in value since it was originally purchased. In this case, you can increase the cost basis to the value of the property at the time it was purchased to lower your total capital gains taxes if you decide to sell it later. If you decide to sell the house several years later, you can deduct any other expenses like closing costs, so that you can lower the amount of capital gains taxes that you have to pay.

There are other common tax incentives that you can take advantage of if you are willing to make the house your primary residence or turn the property into an investment property.

1031 Exchange on an investment property: 1031 exchanges allow someone to avoid paying capital gains taxes if they sell one investment property and reinvest the proceeds into a similar property. If you inherit a property and then begin treating it as an investment property by renting it to other people, you can take advantage of this tax benefit. Furthermore, there is no limit on the number of times that you can do this.

Example: If you inherit a house for $500,000 and turn it into a rental property, you will not need to pay capital gains taxes on the house. You can rent the property to a long-term tenant or list it on Airbnb. If you decide to sell this house later and purchase a similar investment property, you will not have to pay any capital gains taxes on the proceeds.

Convert to primary residence: Another alternative is to convert this home into your primary residence, as you will be eligible for tax benefits after you live in the home for two years. After this time has passed, you can exclude up to $250,000 in capital gains on the property after you sell it. A benefit of this option is that there is no obligation to invest the proceeds in another property.

Potential Changes in 2026

Based on current laws that are in place, there is a chance that the amount excluded at the federal level may decrease in 2026. There are two major benefits that may be eliminated under the changes, which would increase the amount of capital gains taxes you have to pay.

Step-up basis: The step-up basis allows the person inheriting the property to calculate the cost based on the appraised value at the time they inherit the property rather than the cost that someone paid for the house initially. Biden has proposed removing the step-up basis, and the capital gains taxes will be calculated based on the initial price paid.

Example: You inherit a house that is valued at $800,000, but the person you inherited it from only paid $200,000 before. If you sell the house for $1.2 million later, then the capital gains will be $1 million, rather than $400,000, if the step-up basis is removed. Although the $1 million is still below the federal threshold and won’t be taxed in this case, larger sales could trigger a federal tax. Moreover, some of this could be taxed at the state level depending on which state both people lived in.

Lower Amount: Another proposal would lower the amount that is excluded from taxes to the 2009 levels, at $3.5 million for an estate and $1 million for other assets. The maximum tax rate would also increase to 45%, which means anyone who inherited a multi-millionaire dollar property could be subject to extremely high taxes after 2026, even though they would be exempt from capital gains taxes based on current laws.

Finding an Estate Planner

An estate planner can help you navigate some of these complex issues and develop strategies to implement if laws change by 2026. The best thing to do is find a lawyer who specializes in estate planning and begin discussing plans moving forward. There are multiple options available in the United States, and some choose to either charge a flat fee or charge you on an hourly basis. If you don’t feel comfortable finding an estate planner through an online search, it may be best to talk to people in your community and see if someone will refer you to an estate planner.

Final Thoughts

Estate planning is a very complicated topic, and laws may change by 2026 which could make things even more challenging to navigate. If you already know that you want to leave family members an inheritance, and are worried about legal changes, one of the first steps you can take is to take advantage of the $17,000/year gift. Moreover, if you are planning to inherit a property, it is best to become familiar with laws that can help you. For example, you can take advantage of a 1031 exchange or turn the home into your primary residence. These steps can allow you to be better prepared to navigate any potential legal challenges in 2026.

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This post was written by Sean Allaband

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