What happens when you inherit a home? I had this question brought to me a couple of times in the last month. Is there a bunch of taxes that are going to have to be paid? People are concerned about taxes on an inherited house. Let’s start with the basics.
The basis in a home.
The IRS defines the basis in a home as the original cost or value of the home when it was purchased plus home improvements (an additional room etc.).
For example, what happens when your parents die and leave you the house that they bought 40 years ago for $80,000 with a current market value of $1.5 million. Are the inheritors going to have to pay taxes on the increase from $80,000 to $1,500,000? Would you have to come up with taxes on the $1,420,000 gain?
This is a concern for many people. That is where a little thing called the “Step-Up Basis” comes in handy.
The Step-Up basis is where the IRS lets you “step-up” the value of the property at the date of death. Instead of looking at an increase of $1,420,000 in our previous example, the property’s inherit value at the date of death would be “stepped up” to the current market value of $1,500,000. So, the difference between the value at death and the inherited value would be essentially $0, meaning no capital gains tax would be due. This is a huge relief to many beneficiaries.
What happens if your husband or wife dies, and you inherit the house and decide to sell it? The step-up basis is done the same way. As the surviving spouse, the property basis is valued at the date of death or stepped-up. Meaning no capital gains tax is paid on the sale value verses the property basis. There is one glitch that is in some states related to community property. In non-community property states, the surviving spouse gets only half the stepped-up basis. This is not the case in California and 14 other community property states. In that case the 121 exclusion would kick in. This is the exclusion of a portion of the gain on the sale of the house. The exclusion is $250,000 if single and $500,000 if married.
Using the same example, the spouse would inherit half of the value of $1,500,000 or $750,000. The basis in the home would now be $750,000. The exclusion would be $250,000 so the capital gains tax due would be based on $500,000 instead of $1,500,000.
It can be a bit confusing, but there are many safeguards, so beneficiaries don’t have to pay full taxes on the difference between a home purchased 40 years ago and its current value.