The Big Move: My father died last year without a will. My brother and I finally inherited his house — will we need to pay taxes when we sell it?

United States
Dear MarketWatch,

What is the smart way to sell an inherited house to minimize taxes? 

Here’s the background: My father died without a will. Now, my brother and I inherited my father’s house in New York, which is worth between $ 375,000 and $ 450,000. I am also a resident of New York, while my brother resides in Oregon. Our father passed September 2020. The lawyer who is managing the estate advised we can now sell the house. I have started to clean it out and doing some heavy lifting work such as cutting down trees, painting and refinishing the floors. 

What is the best way to sell the house to avoid capital gains or taxes? Is there a specific timeline that governs this?


Inheritance Issues

‘The Big Move’ is a MarketWatch column looking at the ins and outs of real estate, from navigating the search for a new home to applying for a mortgage.

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Dear Issues,

I’m sorry to hear of your father’s passing, and I can imagine how difficult it has been for you to deal with not only his recent passing but also the messiness that occurs when a loved one dies without a will. This happens more often than you’d think, and even iconic figures like Aretha Franklin have died intestate, leaving their heirs to wade through the murkiness of probate court.

When it comes to capital gains, it’s all about the basis. If you’re unfamiliar, a property’s basis is its cost for tax purposes, including not just how much the home was worth when it was purchased or built but also the cost of any improvements made since then. So when you sell a home that you bought yourself, you calculate the capital gains by subtracting the home’s basis from the sale price of the home. If that calculation produces a positive number, you recorded a gain — and if it’s negative, it’s a loss.

The calculation works a little bit different when it comes to property that’s inherited, regardless of whether the deceased individual had a will or not. Heirs are granted a “step-up” in basis. What that means is that rather than using the home’s value from when it was originally purchased to calculate the capital gain, you use its market value at the time of their death.

With inherited property, the cost basis for the home is based on its value at the person’s death and not when it was originally purchased.

This is a major help to children who are selling their late parents’ homes, because it drastically reduces their potential capital gains. Let’s say your father purchased the home for $ 100,000, but it was worth $ 400,000 on the day he died. If you sold it today for $ 450,000, the capital gain would be just $ 50,000 rather than $ 350,000 because of the stepped-up basis. You would only owe taxes on that $ 50,000, not the full sale price of the home.

So depending on what the home was worth when your father died last September and what you could sell it for now, you and your brother may not be facing much of a tax bill. Of course, many towns and cities across the country have seen home prices skyrocket over the past year, which may increase how much of a tax bill you’re facing.

There are a handful of ways you can reduce the tax liability for the property. For starters, keep track of any costs incurred in getting the home into a sellable state. The costs of paint, floor wax, carpentry or plumbing can all be deducted from the capital gain.

The cost of work done to get a home ready to be sold can be deducted from any capital gains incurred when it’s sold.

The best way to avoid capital gain taxes on the home would be to live in the home yourself. When someone sells a primary residence, they can exclude up to $ 250,000 of the capital gains from their taxes ($ 500,000 for joint filers), which could potentially nullify the tax bill entirely on the home’s sale.

To qualify for this exclusion, you must have lived in the home for two of the last five years. Given that you and your brother both inherited the home though, this could introduce more complication into the proceedings and other legal ramifications that might not make it worthwhile to pursue.

Another option for avoiding capital gains taxes would be to convert the home into a rental property. This would make the home an investment, so if you and your brother were to later on sell the home and reinvest the proceeds into another investment property, you could qualify for a capital-gains exemption because it would be a 1031 exchange for tax purposes.

Should you choose to sell now, you should consider the timing of the sale. Typically with inherited property, the best way to avoid a big tax bill is to sell the home immediately, because you reduce the likelihood that it will appreciate much in value above the value used for the stepped-up basis. Unfortunately, because of the time it took to sort out your father’s estate, that wasn’t possible. Still, time might be of the essence here because it’s likely continuing to accrue value by the day.

Given that almost a full year has passed since your father’s death, you may want to consult a real-estate agent to get a more accurate picture of what the home is worth now and what it was worth when he died. Then, you and your brother should discuss the best course of action with an accountant to determine which strategy would best reduce your tax bill.

Even if you do end up owing some money in taxes on the sale of the home, I hope you and your brother can still view this as a wonderful gift that your father has given you. Hopefully the money you each get to keep will help ensure a bright financial future for both of you and allow your father to continue to take care of you even after his passing.