While inheriting property, whether unexpectedly or not, can be a blessing for some, finding yourself suddenly owning an expensive property can also be an incredibly challenging circumstance.
When you inherit property from a passed loved one, you’re inheriting more than just the house itself: You’ll be responsible for all tax liabilities related to the inherited property, including federal estate tax and capital gains tax, as well as become responsible for all outstanding debts, such as a mortgage.
On top of that, inheriting real estate also comes with a set of non-legal yet equally crucial responsibilities, such as deciding to sell the property, make it your primary residence, or even turn it into a rental property to help offset expenses and even make a profit.
Owning a second property can be beneficial for many families looking to build more equity, but if you’re not ready to deal with all the tax liabilities and responsibilities that come with it, you’ll have to be ready to implement an exit strategy, whether it’s selling as fast as you can or avoid paying taxes in any other way.
So, what are the tax implications of inheriting a house?
If you’ve just inherited or are about to inherit a property in California, here’s all you need to know about inheritance tax on house in California, from the estate tax rate you’ll likely be facing to what you’ll need to do to avoid hefty taxation!
Federal, State, and Inheritance Tax on House Rules Explained
First things first, let’s go over all the federal estate taxes, inheritance taxes, and state tax you’ll be expected to pay when inheriting an asset in the state of California, so you can get familiar with what’s expected of you as the recipient.
When a person dies and leaves an asset behind for their family, the recipient automatically becomes responsible for paying a number of different taxes the asset is liable for, including federal estate tax, state inheritance tax, and capital gains taxes.
Luckily, that doesn’t necessarily mean you’ll have to add all these taxes onto your tax bill as soon as you become a beneficiary of an inherited home.
In fact, you might end up paying the minimum taxable amount or almost nothing at all as long as you fit certain thresholds!
Generally speaking, most people won’t have to pay any federal estate tax, as according to the latest IRS regulations, you’ll only have to pay federal estate tax if the assets in question are worth $11.70 million or more, which likely won’t be the case in the majority of inheritance cases.
If you inherit a property in California, you also won’t have to pay state estate taxes, making the process a lot simpler and affordable, but that doesn’t mean you won’t have to prepare for other tax considerations.
So, let’s go over all the different tax rules you could be subjected to and see what, exactly, you could be responsible for paying:
Inheritance Tax Vs estate tax
What’s the difference between inheritance tax and estate tax?
In short, inheritance tax on house refers to what the beneficiary is expected to pay, while the estate tax refers to the amount that’s taken out of the deceased’s estate before the inheritance goes through. Depending on the asset’s location and your relationship to the estate’s owner, you will be expected to pay both or neither of them.
So, how do estate taxes work?
On a federal level, estate taxes are only applied to assets over $11.70 million, with the tax rate ranging from 18% to 40%. Aside from the federal government, a small number of states also charge estate tax which recipients will be subjected to unless they are a spouse of the deceased.
The good news is that California is not one of these states, so unless the property is in a state like Connecticut, Illinois, Maryland, New York, Massachusetts, or Washington, this tax won’t be applied to your inherited property.
Keep in mind that, for tax purposes, both federal and state estate taxes are assessed on the estate’s fair market value at the time of their passing (called step-up basis), rather than on what the original owner paid for their asset. This can either be a benefit or a hindrance: While the property’s appreciation over time will be taxed, you also will be protected from being taxed on higher property values that have since decreased.
The rates you’ll be charged for state inheritance tax, on the other hand, will depend on the value of the property and your relationship with the deceased, but this tax as a whole will only apply to a small handful of states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania).
In addition to that, there is no federal inheritance tax in the U.S., meaning that no matter where you live and where your inherited property is located, you won’t be liable for even more property taxes!
What About Capital Gains Tax?
But while properties in California are not subjected to either state inheritance tax or estate tax, the last common addition to your inheritance tax bill, capital gains tax, remains the biggest tax expense facing beneficiaries in California.
Capital gains are a special type of tax that relates to the profit an asset like real estate generates once it’s sold, and if you decide to sell the inherited house down the line, you will be subjected to it in the state of California. This means that the taxes you’ll pay will be based on the difference between the step-up basis, meaning the fair market value at the time of inheritance established by the IRS and the final selling price.
If you decide to keep the home and either use it as a residence or rent it out to tenants, on the other hand, you will be eligible for capital gains tax exclusion.
How to Avoid Inheritance Tax and Capital Gains Tax in California
So, the good news is that if your inherited property is in California, you won’t have to pay any state inheritance tax on house at all, and on top of that, the few states that apply inheritance tax for asset recipients are already dwindling down due to its increasing unpopularity.
Some people go as far as calling it a “death tax”, so it’s not surprising that even the few states that still apply it are considering scrapping it altogether!
Avoiding capital gains tax, however, is a whole different challenge: In most cases, your capital gains liability will kick in as soon as you sell the inherited property, and it can be quite hard to assess how much you’re going to pay in advance as the IRS taxes capital gains differently than other inheritance taxes.
In fact, how much you’re going to pay will largely depend on how long you held the asset for.
You might be charged a short-term capital gains tax rate if you have held the asset for less than one year, while you’ll be taxed according to the long-term capital gains tax rate if you have held it for longer than one year.
As of 2021, the maximum you could pay for short-term capital gains is 37%, while in the case of long-term capital gains you can expect to be taxed either 0%, 15%, or 20% depending on your income and marital status.
Keep in mind that capital gains will only be applied if you sold the property at a profit, so if you ended up selling it for less than what the deceased owner paid for it, you’ll be able to claim a capital loss deduction!
But as a general rule of thumb, capital gains will end up on your tax bill and potentially eat into your taxable income, so if you find yourself owning a property through inheritance, you’ll have to be prepared to deal with hefty taxation.
Now, what can you do if you want to sell your inherited home and make a profit while avoiding paying hefty capital gains taxes? Here are four ways you can avoid capital gains tax when you sell your inherited property:
Sell the Property as Fast as You Can
The easiest way to avoid property headaches and capital gains tax is to sell the home as fast as possible, so the sale will be classed as a short-term capital gain and be taxed at a much lower rate.
This means that if you don’t let the property appreciate over time and sell at the same price it was worth according to the step-up basis (the value at the time of the inheritance), you’ll be able to avoid paying capital gains altogether!
Of course, selling an inherited home that fast is no easy feat, and you’ll have to factor in the expenses of hiring a realtor to list it on top of appraisals, upgrades, and any other property expense you’ll need to shoulder in order to sell quickly.
The best course of action, in this case, will be to step away from the traditional selling path and get in touch with a cash buyer instead!
Make the Property Your Primary Residence
Another effective yet definitely more complex way to avoid capital gains tax is to convert the inherited property into your primary residence and occupy it for at least two years, so you can take advantage of the lenient IRS capital gains tax rules for a primary residence.
If you are single, you will already be allowed a $250,000 tax write off for the sale, while if you are married and filing jointly you’ll be able to shave off as much as $500,000 off your tax bill, which might come up as the entire amount of the sale.
You can only qualify for these exemptions if you’re applying for your primary residence, so if you are open to relocating and living in the inherited property for at least two years, you’ll be able to avoid paying capital gains altogether!
Defer Your Taxes as An Investment Property
Another more complex way of avoiding taxes on inherited property is to turn the inherited asset into an investment property, renting it out to tenants for a sizable period of time before selling it and filing a 1031 exchange to purchase another investment property.
When you invest in another investment property to replace the inherited home under the 1031 exchange, you’ll be able to defer capital gains taxes, which you can continue doing with multiple properties almost infinitely, growing your portfolio, equity, and profit at the same time.
Of course, this course of action is best suited for those who want to enter the real estate investing world and become real estate professionals, so if you’re not prepared to deal with such a complex journey, you’ll be better off selling as fast as you can, keeping the house as a second home, or simply refusing the inheritance in the first place.
And on that note…
Disclaim the Inheritance Altogether
The fastest and perhaps most convenient way to avoid paying any tax on your inherited asset is to simply disclaim the inheritance altogether.
This means that you can choose to refuse to inherit once you are informed of your loved one’s will, saving you from all the tax hassles and responsibilities that come with the asset.
Keep in mind that you won’t be able to change your mind once you disclaim the inheritance, and depending on your situation, refusing your loved one’s will might be a lot harder than just keeping or selling the home.
Frequently Asked Questions (FAQs)
1. Can I rent out an inherited property immediately after inheriting it?
Yes, you can rent out the inherited property immediately. However, consider any legal, tax, and maintenance responsibilities associated with becoming a landlord.
2. How does the “step-up in basis” affect the value of an inherited property?
The “step-up in basis” adjusts the property’s value to its fair market value at the time of the original owner’s death, potentially reducing capital gains tax if sold.
3. What if the inherited property has a mortgage?
If the property has a mortgage, you’ll need to continue making payments or settle the debt, possibly through the sale of the property or refinancing.
4. Are there any exceptions to capital gains tax for inherited properties used for business?
Yes, if the inherited property is used for business purposes, different tax rules and deductions may apply, potentially reducing the tax burden.
5. Can siblings jointly inherit a property and what are the implications?
Siblings can jointly inherit a property, but they must agree on property management, expenses, and future plans, whether to sell, rent, or use it.
6. How does probate affect the inheritance of a property?
Probate is the legal process of transferring property ownership after death. It can impact the timeline and legal procedures for inheriting the property.
7. Are there any property tax implications for inherited property in California?
Inherited properties in California may see a reassessment in property taxes, especially if the property’s value has significantly increased since the last assessment.
Inheriting property in California comes with unique tax implications and responsibilities. Understanding these, from capital gains to estate tax nuances, is essential for making informed decisions and managing the inheritance efficiently and legally.