The massive step: my father died final 12 months and not using a will. My brother and I lastly inherited his home – do we’ve to pay taxes on the sale?

Dear MarketWatch,

What's the Smart Way to Sell an Inherited Home to Minimize Taxes?

Here is the background: My father died without a will. Now my brother and I have inherited my father's house in New York, which is worth between $ 375,000 and $ 450,000. I also live in New York while my brother lives in Oregon. Our father died in September 2020. The lawyer who runs the property advised us to sell the house now. I started cleaning it up and doing some heavy lifting work like cutting down trees, painting, and refurbishing the floors.

What's the best way to sell the house to avoid capital gains or taxes? Is there a specific schedule that regulates this?


Inheritance problems

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Love problems,

I am sorry to hear of your father's death, and I can imagine how difficult it was for you not only to deal with his recent death, but also the mess that comes when a loved one dies without a will. This happens more often than you think, and even iconic figures like Aretha Franklin have died without a will, leaving their heirs to wade through the darkness of the probate court.

When it comes to capital gains, it's all about the base. If you're unfamiliar, the basis for it is the tax cost of a property, including not just the value of the home at the time it was bought or built, but the cost of any improvements made since then. So when you sell a home that you bought yourself, calculate the capital gain by subtracting the home base from the home selling price. If this calculation results in a positive number, then you've made a profit – and if it's negative, it's a loss.

In the case of inherited wealth, the calculation works a little differently, regardless of whether the deceased had a will or not. The heirs are granted a “step-up” on the basis. This means that instead of using the value of the home at the time of the original purchase to calculate capital gains, you are using its market value at the time of death.

In the case of inherited property, the cost basis for the home is based on the value at the time of death and not at the time of the first purchase.

This is of great help to children selling their late parents' home as it dramatically reduces their potential capital gains. Let's say your father bought the house for $ 100,000, but it was worth $ 400,000 the day he died. If you were to sell it for $ 450,000 today, the capital gain would only be $ 50,000 rather than $ 350,000 due to the increased base. You would only owe tax on that $ 50,000, not the full sale price of the home.

Depending on what the house was worth when your father died last September and what you could sell it for now, you and your brother might not face much of a tax bill. Of course, many cities across the country have seen property prices soar over the past year, which can add to the tax burden.

There are a handful of ways to reduce the tax liability on the property. First of all, keep track of all the costs involved in getting the house into a salable condition. The cost of paint, floor wax, carpentry or plumbing can all be deducted from capital gains.

The cost of preparing to sell a home can be deducted from the capital gains incurred on the sale.

The best way to avoid capital gains taxes on your home is to live in your own home. When someone sells a primary residence, they can exclude up to $ 250,000 of capital gains from their taxes ($ 500,000 for joint claimants), potentially nullifying the tax bill on home sales.

The prerequisite for this exclusion is that you have lived in the apartment for two years in the past five years. However, since you and your brother both inherited the house, it could complicate the process and have other legal ramifications that may not be worth pursuing.

Another way to avoid capital gains taxes would be to convert your home into a rental property. This would make the home an investment. If you and your brother later sell the house and reinvest the proceeds in another investment property, you may qualify for a capital gains exemption as it is a 1031 exchange for tax purposes.

If you decide to sell now, consider the timing of the sale. Typically with inherited properties, the best way to avoid a high tax burden is to sell the home immediately, as you will reduce the likelihood of its value rising well above the value that was used for the top-up base. Unfortunately, this was not possible due to the time it took to sort out your father's estate. Still, time could be of the essence here as it is likely to keep increasing in value day by day.

Since almost a full year has passed since your father died, it is a good idea to consult a real estate agent for a more complete picture of what the house 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 burden.

Even if you do have to pay tax on the sale of the house, I hope that you and your brother can still consider this a wonderful gift from your father. Hopefully the money you all keep will help ensure both of you a bright financial future and allow your father to continue to look after you after he dies.

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