Quick overview

When you inherit real estate, the Internal Revenue Service generally adjusts the asset’s cost basis to its fair market value (FMV) on the decedent’s date of death — the so‑called step‑up in basis. That adjustment usually reduces or eliminates taxable capital gains when you sell. But the sale can still trigger taxes in several situations: significant post‑death appreciation, rental history and depreciation, applicability of the home‑sale exclusion, the net investment income tax, and state income taxes. This guide walks through the rules, real‑world examples, common pitfalls, and practical next steps.

How the step‑up in basis works

  • Basis at death: For most inherited property, your cost basis equals the FMV on the date of the decedent’s death (or an alternate valuation date in limited estate‑tax situations). See IRS Publication 551 for details (IRS, Publication 551).
  • Calculation on sale: Capital gain = Sale price minus selling costs (commissions, closing costs) minus stepped‑up basis.
  • Long‑term vs short‑term: If you sell the inherited property at any time after the decedent’s death, the gain is treated as a long‑term capital gain for federal income‑tax purposes regardless of how long you personally held it.

In my practice I often see heirs assume the original purchase price is their basis; confirming the step‑up with an appraisal and estate paperwork is the first important step.

Common scenarios and tax consequences

1) No gain (or small gain)

  • Example: Decedent bought house decades ago for $100,000; FMV at death = $400,000; you sell for $405,000. Your taxable gain is $5,000 (minus selling costs). Thanks to the step‑up, most prior appreciation is not taxed.

2) Large post‑death appreciation

  • If you hold the property after inheriting and it appreciates further before you sell, you’ll owe capital gains tax on the difference between sale price and the stepped‑up basis. Rates depend on taxable income and are generally 0%, 15%, or 20% (plus possible surtaxes). The 3.8% Net Investment Income Tax (NIIT) can also apply to high‑income filers (IRS guidance on NIIT).

3) Property used as rental before death (and after)

  • Because the basis steps up to FMV at death, depreciation previously claimed by the decedent does not reduce your stepped‑up basis. That means past depreciation is effectively wiped out for gain calculation. However, any depreciation you claim after inheritance (if you operate it as a rental) can create depreciation recapture if you later sell — taxed under Section 1250 rules at ordinary plus recapture rates. Consult a CPA before electing to depreciate an inherited rental.

4) Primary residence exclusion (Section 121)

  • The $250,000/$500,000 exclusion for the sale of a primary residence generally requires ownership and use tests (you must have owned and lived in the home for at least two of the five years before the sale). Because inherited property usually does not meet these ownership requirements, most heirs cannot claim the full Section 121 exclusion. If you move into and live in an inherited home, there are limited scenarios where you may qualify after meeting the ownership/use tests — check IRS guidance and consult an advisor.

5) Alternate valuation date and estate tax implications

  • For estate tax purposes only, an executor can sometimes elect alternate valuation six months after death. That election can lower the value reported for estate tax and may affect the basis used by heirs if and only if the election is made on the estate tax return (Form 706) — a complex decision that usually only matters for estates approaching federal estate‑tax thresholds. See Form 706 instructions and Publication 559 (IRS) for rules.

6) State income and transfer taxes

  • State income tax rules vary. Some states tax capital gains and have different basis rules or estate taxes. Don’t assume federal treatment is identical to state treatment.

Practical steps to prepare for sale

  1. Confirm title and how you inherited the property
  • The mechanics of how title passed (will, trust, joint tenancy, beneficiary deed) affects your tax paperwork and who signs closing documents.
  1. Obtain an appraisal or other evidence of FMV at date of death
  • A contemporary appraisal is the best evidence of the stepped‑up basis, especially if the estate is large or later audited.
  1. Gather documentation
  • Estate tax return (if filed), death certificate, closing statements from the decedent’s purchase, and any appraisals or comps used by the estate.
  1. Determine whether the property was used as rental or personal residence
  • If the property was a rental, determine depreciation history and whether you plan to use depreciation going forward.
  1. Estimate federal and state tax exposure
  • Run scenarios showing sale price, selling costs, stepped‑up basis, and resulting gain. Apply likely federal capital gains rates and the NIIT if applicable; add state tax estimates.
  1. Consider timing and alternatives
  • Selling quickly after death often preserves the step‑up benefit with minimal post‑death appreciation tax. If you prefer to hold, analyze whether converting to a rental, doing a 1031 exchange (only available for qualifying investment real estate), or gifting the property makes sense. 1031 like‑kind exchanges are restricted to real property used for business or investment and carry strict timelines — consult a tax professional.

Sample calculation

Assume:

  • FMV at date of death (stepped‑up basis): $600,000
  • Sale price: $650,000
  • Selling costs (commission, closing): $30,000

Taxable gain = 650,000 – 30,000 – 600,000 = $20,000

If you are in a 15% long‑term capital gains bracket, federal tax ≈ $3,000. Add NIIT (3.8%) if you’re subject, plus any state tax. This demonstrates how the step‑up can dramatically reduce taxable gain compared with the decedent’s original purchase price.

Common mistakes to avoid

  • Assuming you inherit the decedent’s original basis. (You usually get the stepped‑up basis.)
  • Failing to secure a date‑of‑death appraisal or to document how FMV was established.
  • Automatically depreciating inherited property without analyzing prior tax history and future plans.
  • Assuming the primary residence exclusion applies—often it does not for heirs.

When to call a professional

  • The estate is large or the executor elected an alternate valuation date.
  • The property was used in a business or as a rental, and depreciation history exists.
  • You plan to do a 1031 exchange or convert the property from personal to rental use.
  • You live in a state with estate or inheritance taxes that could change the calculation.

In my advisory work I routinely coordinate between appraisers, estate attorneys, and CPAs to ensure the stepped‑up basis is documented and that heirs understand timing tradeoffs. A small difference in documented FMV or a missed depreciation schedule can change tax outcomes materially.

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Key takeaways

  • The step‑up in basis usually eliminates tax on appreciation that occurred before death, but you can still owe capital gains tax on appreciation that occurs after death and on other items like recaptured depreciation taken after inheritance.
  • Document FMV at date of death, confirm title transfer mechanics, and run tax scenarios (including NIIT and state taxes) before selling.
  • Consult a CPA and estate attorney for complex estates, rental properties, or when considering 1031 exchanges.

Professional disclaimer: This article is educational only and does not constitute tax, legal, or investment advice. For guidance tailored to your situation, consult a qualified tax professional or attorney.

Authoritative sources: IRS, Publication 551: Basis of Assets; IRS pages on inherited property and capital gains; IRS NIIT guidance (see https://www.irs.gov and specific publications).