What are the tax consequences to my heirs when they sell inherited real property?

11415768915_83a98098aaIf you own real property and are looking to transfer it to your children or if you inherited real property and want to sell it, then you should consider the tax consequences. The sale of real property is a taxable event that must be reported on the seller’s income tax return for the year in which the property is sold. Depending on the value of the cost basis for the property and the sales price, there may be a capital gain which is taxable at the federal and state capital gains tax rate. A capital gain or loss is determined by taking the sales price of the real property and subtracting the cost basis. If the proceeds of the sale is greater than the cost basis (plus closing costs) then that amount is the capital gain. Usually the seller determines the cost basis of the property by taking the initial purchase cost of the property, and adding to that the cost of any capital improvements made to property. However, the rules are different for inherited real property.

If you inherit real property, the cost basis for the real property is the fair market value of the property as of the date of the death of person you inherited it from. This is called a “step-up in basis” because the fair market value is usually greater than the cost basis of the property, so the basis will “step up” to the higher amount. This also means that inherited property is usually acquired tax free as of the owner’s date of death. It is important to note that real property which is gifted to a person does not receive this “step up” in cost basis. Therefore, if you own property and are considering transferring that property to your children, you should consider the tax consequences before making a gift of the property. Transferring the deed to the property by putting your children’s names on the deed could end up costing them significantly in taxes. In most cases, if you wish to transfer property to your children, it is better to transfer the property to a living trust and not directly to your children. The Living trust can be drafted to allow your children to receive the “stepped up” cost basis upon your death. While gifted property does not usually get the stepped up basis, property transferred through a trust can receive the stepped up basis and this can result in a significant tax savings when the property is sold. You should speak to an experienced attorney to get more information on the tax consequences of the sale of inherited property.

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