Do I automatically pay taxes when I inherit property?

An inheritance is a stroke of luck that can certainly improve someone's financial situation – but it can also make your taxes difficult. When you inherit property or assets (as opposed to cash), you generally don't owe any taxes until you sell those assets. These capital gains taxes are then calculated on what is known as a tiered cost basis. This means you only pay tax on the capital gains that occur after the property is inherited. A financial advisor can help you make sure you're filing your tax returns correctly. Let's break down how capital gains are taxed on inherited wealth.

When you inherit property, you do not automatically pay taxes

There are three main types of taxes that cover inheritances:

• inheritance taxes – These are taxes paid by an heir on the value of the estate he inherited. There is no state estate tax, and only six states levy some form of estate tax. Due to the country-specific nature of inheritance taxes, this topic is beyond the scope of this article.

• inheritance taxes – These are taxes paid out of the estate itself before anyone inherits it. Inheritance tax has a minimum amount. In 2021, that threshold was $11.7 million. As with all other tax brackets, the government only taxes the amount in excess of this minimum threshold. That is, if your estate is worth $11,700,001, the government collects taxes on $1. The rest remains tax-free.

• capital gains taxes – These are taxes paid on the increase in the value of assets inherited by an heir through an estate. They are only charged if you sell the assets for a profit, not in the case of an inheritance.

Cash that you inherit will be taxed by either inheritance tax (if applicable) or inheritance tax. In the event of an inheritance tax, it is your responsibility to file and pay that tax. In the case of an estate tax, the IRS taxes the estate directly. It is therefore unusual for an heir to owe taxes, including income tax, on inherited money.

The story goes on

The IRS does not automatically tax all other forms of property that you may inherit. This means that if you inherit real estate, shares or other assets, you usually do not have to pay any taxes on the inheritance. For example, if you inherit your grandparents' home, the IRS will not tax the value of the property upon receipt. (There are exceptions to this rule in certain circumstances. Most often, these exceptions apply to income-generating assets, such as income investments, retirement accounts, or ongoing businesses.)

However, you will have to pay capital gains tax if you decide to sell this property.

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Capital gains are heavily taxed

When you inherit property, whether it's real estate, stocks, or just about anything else, the IRS applies what's called a step-up basis to that asset. This means that the base price of the asset is reset to the value on the day of inheritance for tax purposes. If you inherit a property and then immediately sell it, you don't have to pay taxes on those assets.

Capital gains taxes are paid when you sell an asset. They will only be levied on the profits (if any) you make from that sale. Say you buy a stock for $10. Later, you sell the same stock for $50. You have to pay capital gains tax on the $40 you earned from this transaction.

There are two prices involved in determining a capital gains tax: the selling price (how much you sold the asset for) and the original cost basis (how much you bought it for). In our example, the selling price of this stock is $50 and the original cost basis is $10. You tax the difference, which in turn results in $40 of taxable income.

Now imagine the scenario that years ago your grandparents bought their house for $100,000. Today it has increased in value and is worth $500,000. If they sold the house, they would pay capital gains taxes on $400,000:

• Selling Price ($500,000) – Original Cost Base ($100,000) = $400,000

Instead, however, they die and leave the house to you. At the time of your inheritance, the IRS takes into account that the original cost of the home will be increased to the current market value. That means if you sell it immediately, you pay no capital gains tax:

Suppose you keep the house for a year and during that time the price of that house increases by $100,000. If you sell it, you would only owe capital gains tax on $100,000:

• Selling Price ($600,000) – Increased Original Cost Basis ($500,000) = $100,000 Taxable Capital Gain

Because of the increased cost base, it is relatively rare for heirs to have to pay significant taxes on any inheritance amount.

The conclusion

There are a few ways to avoid paying capital gains tax on inherited property that are worth considering if you are the beneficiary of an estate or trust. When you inherit property, the IRS applies what is called a step-up cost basis. You do not automatically pay taxes on the property you inherit. If you sell, you only owe capital gains tax on gains made on the asset since you inherited it.

Tax tips

• Capital gains can be one of the most complicated sections of tax legislation. Fortunately, a financial advisor can clarify the best way to handle such situations. Finding a qualified financial advisor doesn't have to be difficult. SmartAsset's free tool puts you in touch with up to three financial advisors in your area, and you can interview your matching advisor for free to decide which one is right for you. If you're ready to find an advisor, get started now.

• Use a free federal income tax calculator to quickly estimate what you'll owe “Uncle Sam.”

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