How to avoid paying capital gains tax on inherited property
Inheriting property comes with significant tax implications when you sell. Capital gains tax (CGT) on inherited property can substantially reduce your inheritance value—but several legal strategies can help you minimize or eliminate this tax burden entirely. This guide covers six proven methods to avoid capital gains tax on inherited property, plus special considerations for US expats with foreign real estate.
This article is brought to you by Taxes for Expats (TFX) – a top-rated tax firm serving US citizens, residents, and anyone with US tax obligations, both at home and abroad. Need guidance on capital gains tax on inherited property? We're here to help. Schedule your free discovery call, and we’ll review your case and walk you through the next steps.
| Stepped-up basis | Resets property value to fair market value at the inheritance date, eliminating all previous owners' capital gains |
| $250K/$500K exclusion | Available after living in an inherited property as a primary residence for 2 of 5 years before sale |
| 1031 exchange | Requires strict timing: identify replacement property within 45 days, complete purchase within 180 days |
| Foreign inherited property | Must be reported on US tax returns with USD conversion; foreign taxes paid may qualify for credit |
| Immediate sale | Minimizes the appreciation period, typically resulting in minimal to zero capital gains tax |
| Professional appraisal | Essential to document stepped-up basis value for IRS reporting accuracy |
How to avoid paying capital gains tax on inherited property
When dealing with an inherited house or inherited land, several strategies can help you legally reduce or eliminate capital gains tax obligations.
Here are six effective approaches:
| Method | Potential Tax Savings | Time Required | Complexity | Best For |
|---|---|---|---|---|
| Immediate sale | Up to 100% of gains | 1-6 months | Low | Those who don't need property; want quick liquidity |
| Primary residence conversion | Up to $250K-$500K | 2+ years minimum | Medium | Those needing housing or between homes |
| 1031 exchange | 100% (deferred indefinitely) | 45-180 days | High | Real estate investors with replacement property |
| Gifting to heirs | Shifts the tax burden | Immediate | Medium | Estate planning; heirs in lower brackets |
| Irrevocable trust | Varies significantly | 6+ months setup | High | High-value estates; long-term planning |
| Charitable donation | 100% + income deduction | 1-3 months | Medium | Philanthropic goals; high-value property |
Each method has specific requirements and benefits. Let's explore them in detail:
1. How does selling inherited property immediately avoid capital gains tax?
One of the most straightforward ways to avoid paying taxes on inherited property is selling it shortly after receiving it. This approach takes advantage of the "stepped-up basis" rule.
The stepped-up basis allows you to inherit the property at its fair market value at the time of the previous owner's death rather than the original purchase price. This effectively eliminates any capital gains that occurred during the previous owner's lifetime.
2. Can I avoid capital gains tax by living in the inherited property?
If immediate sale isn't your preference, consider moving into the inherited house and making it your primary residence.
When you live in a property as your main home for at least two of the five years before selling it, you can qualify for the home sale exclusion. This allows you to exclude up to $250,000 of capital gains from your taxable income ($500,000 for married couples filing jointly).
This approach works well if you're between homes or planning to downsize anyway. By living in the inherited property, you can avoid capital gains taxes while solving your housing needs.
3. What is a 1031 exchange, and how does it defer capital gains tax?
If the inherited property is an investment property, the 1031 exchange (also known as a like-kind exchange) offers a powerful tax deferral strategy.
This IRS provision allows you to defer capital gains taxes by reinvesting the proceeds from your sale into a similar investment property. While this doesn't eliminate taxes permanently, it postpones them indefinitely if you continue to exchange properties throughout your lifetime.
The 1031 exchange has strict timelines and requirements. You must identify a replacement property within 45 days of selling the inherited property and complete the purchase within 180 days.
4. Does gifting inherited property to heirs eliminate capital gains tax?
Rather than selling the inherited property, you might consider gifting it to your heirs. This approach can be particularly beneficial if you don't need the proceeds from the sale immediately.
When you gift property during your lifetime, the recipient takes on your basis (the stepped-up value you inherited). While this doesn't eliminate taxes, it can shift the tax burden to someone who might be in a lower tax bracket.
5. How can an irrevocable trust help avoid capital gains tax?
Establishing an irrevocable trust can provide significant tax advantages for inherited property. By placing the property in a trust, you can potentially reduce estate taxes and provide more control over how and when the property passes to beneficiaries.
Certain types of trusts can also help avoid capital gains taxes through strategic timing of distributions or by taking advantage of charitable giving provisions.
Consult with an estate planning attorney to determine which type of trust might be most beneficial for your specific situation.
6. Can I donate inherited property to charity and avoid capital gains tax?
If you're charitably inclined, donating the inherited property to a qualified charitable organization can eliminate capital gains taxes while generating a significant income tax deduction.
You can deduct the property's fair market value at the time of donation, potentially offsetting your other income tax obligations. This approach is particularly practical if the property has appreciated significantly since you inherited it.
The difference between inheritance tax and capital gains tax
Many property heirs confuse inheritance tax with capital gains tax. While both relate to inherited property, they serve different purposes and apply at different times.
Inheritance tax is levied on the estate of the deceased person before assets are distributed to heirs. Only six US states currently impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The federal government does not impose an inheritance tax (though it does impose an estate tax on estates exceeding $13.61 million in 2024).
Capital gains tax, however, applies when you (the heir) sell inherited property for more than its stepped-up basis value. This is a federal tax that applies regardless of which state you live in.
Key distinction: You may owe capital gains tax even if no inheritance tax was paid, and vice versa. Most inherited property in the US involves zero inheritance tax but potential capital gains tax upon sale.
Example scenario: You inherit a house in California (no inheritance tax state) worth $500,000. No inheritance tax is owed when you receive it. Three years later, you sell it for $600,000. You'll owe capital gains tax on the $100,000 appreciation, not on the full $600,000 sale price.
When do you pay capital gains tax after inheriting property?
Understanding when capital gains tax applies to inherited property helps you plan your strategy effectively. Here are the key scenarios:
Personal use property
If you inherit property and use it as your personal residence, you'll only owe capital gains tax if you sell it for more than its stepped-up basis and don't qualify for the home sale exclusion discussed earlier.
The home sale exclusion allows you to exclude up to $250,000 of capital gains from your taxable income ($500,000 for married couples filing jointly) if you’ve lived in the property for at least two of the five years before selling it.
This strategy can help you avoid capital gains taxes on inherited property by converting it into your primary residence.
Investment property
Inherited investment properties like rental homes are subject to capital gains tax when sold. The tax is calculated on the difference between the sales price and the stepped-up basis.
However, you may also be eligible for depreciation deductions while you own the property, which can offset some of the rental income taxation.
Stepped-up basis considerations
The stepped-up basis rule is crucial for inherited property taxation. This provision resets the property's tax basis to its fair market value at the time of the previous owner's death, essentially wiping out any gains that occurred during their ownership.
Proper documentation of the property’s value at the time of inheritance is essential. To ensure you have a solid foundation for calculating your tax liability, consider getting a professional appraisal to establish the stepped-up basis accurately.
Special considerations for foreign inherited property
If you're a US citizen or green card holder who inherits property located outside the United States, the stepped-up basis rules still apply, but with a few added layers of complexity. Even if the sale occurs entirely abroad, you must report the transaction on your US tax return.
Americans are taxed on worldwide income, including capital gains from selling foreign real estate.
Here’s what else to keep in mind:
- Convert all figures (sales price, expenses, basis) into USD using the exchange rate on the date of each transaction.
- Foreign taxes paid on the sale (e.g., foreign capital gains tax or transfer tax) may qualify for a foreign tax credit on your US return, using Form 1116.
Selling immediately or renting out
The timing of your sale can significantly impact your tax situation. You can avoid capital gains taxes on inherited property by minimizing the time for appreciation.
Selling immediately after inheritance typically results in minimal capital gains tax because there's little time for the property to appreciate beyond its stepped-up basis.
If you decide to rent the property instead, you'll need to consider both income tax on rental proceeds and potential capital gains tax when you eventually sell.
Estate or trust sales
If the inherited property is sold by the estate or trust before distribution to heirs, different tax rules apply. The estate or trust will be responsible for paying any capital gains tax on the sale.
This scenario can be beneficial if the estate or trust has a lower tax rate than the individual heirs, potentially helping to avoid capital gains by shifting the tax burden.
Donating to charity
Charitable donations of inherited property can eliminate capital gains tax while providing a tax deduction equal to the property's fair market value, making this an attractive option for those with philanthropic goals looking to not only support good causes but to be financially prudent.
How to report inherited property sale on your tax return?
When you do sell inherited property, proper reporting is essential to avoid penalties and ensure compliance with IRS regulations:
You'll need to report the sale on Schedule D (Form 1040) and Form 8949. These forms require you to provide details about the acquisition date, sale date, purchase price (the stepped-up basis), and selling price.
Be particularly careful when declaring the tax basis. Overstating the basis to reduce taxable gain can lead to penalties. If you're unsure about the correct basis, consult with a tax professional who specializes in inheritance taxation.
If this is for the sale of a primary residence, we have covered this exact topic before. Our article covers capital gains tax on the sale of your property, whether it's at home or abroad.
It also covers the IRS Section 121 exclusion ($250K/$500K), eligibility requirements (two-year residency rule), tax rates based on income, special circumstances (military service, illness, job changes), rules for death/divorce, calculating adjusted basis, partial exclusions, converting to rental property, and treatment for non-citizens who renounce status.
Capital gains tax avoidance scenarios examples
Understanding these strategies in practice helps clarify how they work in real situations.
Example 1: Immediate sale with minimal gains
Situation: Sarah inherited her mother's home in Florida, valued at $450,000 (stepped-up basis) in January 2024. She didn't need the property and sold it in April 2024 for $455,000.
Tax calculation:
- Sale price: $455,000
- Stepped-up basis: $450,000
- Capital gain: $5,000
- Tax owed (15% rate): $750
Result: By selling quickly, Sarah avoided the $67,500 in taxes she would have owed without the stepped-up basis (on the original $150,000 purchase price).
Example 2: Primary residence conversion
Situation: Mark inherited a rental property in Oregon worth $600,000 in 2022. Instead of selling immediately, he terminated the lease, moved in, and made it his primary residence for 2.5 years before selling in 2024 for $680,000.
Tax calculation:
- Sale price: $680,000
- Stepped-up basis: $600,000
- Capital gain: $80,000
- Home sale exclusion: -$80,000 (under the $250,000 limit)
- Taxable gain: $0
- Tax owed: $0
Result: Mark saved $12,000-$16,000 in capital gains taxes by living in the property.
Example 3: 1031 exchange for real estate investors
Situation: Lisa inherited an investment property in Texas valued at $800,000 in March 2024. She sold it for $850,000 in June 2024 and immediately reinvested all proceeds into two smaller rental properties ($425,000 each) through a properly structured 1031 exchange.
Tax calculation:
- Capital gain: $50,000
- Tax deferred through 1031 exchange: $50,000
- Immediate tax owed: $0
- Tax savings: $7,500-$10,000 (deferred)
Result: Lisa deferred all capital gains taxes while diversifying her rental portfolio into two properties with better cash flow.
Example 4: Foreign inherited property
Situation: James, a US citizen living in Germany, inherited his grandmother's apartment in Berlin valued at €300,000 (stepped-up basis). He sold it one year later for €320,000. Germany imposed 25% capital gains tax on the €20,000 gain (€5,000).
Tax calculation:
- Capital gain in USD: $22,000 (at exchange rate)
- US capital gains tax (15% rate): $3,300
- Foreign tax credit for German taxes paid: -$5,500
- Net US tax owed: $0 (foreign tax credit exceeds US liability)
Result: James owed no additional US taxes due to foreign tax credit, but had to report the transaction on his US return with Form 1116.
Example 5: Charitable donation
Situation: Patricia inherited a commercial property in California valued at $1,200,000 with significant appreciation potential. She had strong charitable inclinations and donated the property to a qualified 501(c)(3) organization.
Tax calculation:
- Capital gains tax avoided: $0 (no sale occurred)
- Income tax deduction (at fair market value): $1,200,000
- Tax benefit (at 37% marginal rate): $444,000 deduction value spread over 5-6 years
Result: Patricia eliminated capital gains tax entirely while generating substantial income tax deductions over multiple years.
How can you save the most on taxes when you inherit property?
Navigating the complexities of capital gains tax on inherited property – especially when it involves foreign real estate – requires specialized knowledge and careful planning. The strategies discussed here offer valuable starting points, but each inheritance situation is unique.
Our cross-border tax team specializes in helping American expats handle complex reporting for inherited property. From stepped-up basis calculations to foreign currency conversions and IRS reporting, we’ll guide you every step of the way.
FAQ
No, you don't pay capital gains tax at the moment of inheritance. Capital gains tax only applies when you sell the inherited property for more than its stepped-up basis (the fair market value at the time of the previous owner's death). You can hold inherited property indefinitely without owing capital gains tax.
Stepped-up basis resets the property's tax value to its fair market value on the date of the previous owner's death. This eliminates all capital gains that occurred during the previous owner's lifetime.
You must use the inherited property as your primary residence for at least 2 out of the 5 years before selling to qualify for the home sale exclusion. This allows you to exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains from your taxable income.
The 2 years don't need to be consecutive, but they must fall within the 5-year period ending on the sale date.
No, 1031 exchanges only apply to investment or business property, not personal residences. The inherited property must have been used for rental income, business purposes, or investment before you can execute a 1031 exchange.
Additionally, you must continue using it as investment property (not convert to personal use) before the exchange.
Yes. US citizens and green card holders must report and pay US capital gains tax on worldwide income, including gains from selling inherited property located abroad.
However, you can claim a foreign tax credit f or capital gains taxes paid to the foreign country, which reduces or eliminates double taxation. Use Form 1116 to claim this credit.
Yes, if multiple siblings inherit property as co-owners, each sibling can potentially claim their portion of the $250,000 exclusion ($500,000 if married) if they meet the 2-out-of-5-years primary residence requirement individually.
Example: Two siblings inherit a house together. Both live in it as their primary residence for 2+ years. Upon sale, they can exclude up to $500,000 combined ($250,000 each) of capital gains.
Capital improvements (not repairs) increase your cost basis, reducing capital gains when you sell. Examples include:
Deductible improvements:
Room additions, new roof, HVAC system replacement, kitchen remodel, landscaping
Non-deductible repairs:
Painting, fixing leaks, replacing broken fixtures, routine maintenance
Keep detailed records and receipts for all improvements to document your increased basis.
