While an inheritance can represent a windfall, Uncle Sam always wants his cut. We may not like taxes, but it’s wise to consider them whenever you make any kind of a financial move.
However, you will not necessarily owe taxes on the sale of your inherited home. Your tax liability will depend upon a number of factors. In order to understand what your next move should be, you need to understand several important terms.
Income Tax vs. Capital Gains Tax
Many people spend the vast majority of their life dealing with income tax and only with income tax. Income tax is a tax levied on any income source: wages, tips, and self-employment income. Sometimes, debt forgiveness or prize money can be tacked onto your income tax.
Capital gains tax is a tax levied on the sale of an asset such as stocks, bonds, or real property.
The good news? The capital gains tax rate is lower than the income tax rate. Income tax starts at 10% and can skyrocket to 39.4%, depending upon your tax bracket. The highest capital gains tax will go is 15%, and the lowest two tax brackets pay 0% on capital gains.
You can find your tax bracket here.
So why does capital gains tax come as a shock to so many people? Because most people aren’t used to “out of sight, out of mind” taxes. If you’re not self-employed, then employers pay half of your income tax. The rest comes out of your check. You’re free to use whatever is left, and you might even get a refund at the end of the year.
But nobody’s matching or paying your capital gains tax, which means if you owe any, you may have to pay that amount out-of-pocket when next April comes around. If you didn’t plan for this you could be left with the biggest tax bill you’ve ever seen.
Fortunately, you are not going to be taxed on every dollar of the home sale.
The home’s “basis” is the figure that the IRS uses to determine whether you have made a capital loss, or a capital gain. “Basis” is a fancy way of saying, “this is what the home is worth, in tax terms.”
When you are the primary homeowner, basis is calculated by taking the original sale price of the home and adding the cost of any improvements. For example, if you bought your home for $150,000 and added a $25,000 metal roof five years later, your basis would be $175,000.
However, when you inherit a home, the basis is calculated a little differently. Instead of trying to track down every last improvement or using a sales figure that might be 30 or 40 years old, the IRS uses the Market Value of that home on the date of the decedent’s death.
This actually works in your favor. Aunt Maude may have paid $20,000 for her 3 BR/2 BA home in the 1950s. If she dies in 2016 you do not want the IRS to use $20,000 plus her $12,000 kitchen remodel as your basis. The same home might well sell for $300,000 today, which means you’d owe disproportionate capital gains on the home.
Instead, the IRS says, “That home is worth $300,000,” for the purposes of calculating whether or not you have generated a gain or a loss.
If you generate a gain, the gain is taxable. If you generate a loss, that’s tax deductible. This is a good thing to remember as you continue to think about your next steps.
Calculating Gain or Loss
Calculating whether you’ve generated a gain or a loss is simple.
Let’s take Aunt Maude’s home, with a basis of $300,000, and let’s say you’re the only heir. You sell the home for $350,000. You’ve generated a capital gain of $50,000. If you’re in a modest tax bracket with a 10% capital gains tax you’re going to owe $5,000 at tax time. That might be okay if you remember to set aside the $5,000 before you spend any of your money, but it might come as a shock if you don’t!
However, if you sell the home for $250,000 then you’ve actually created a $50,000 capital loss. You’ll be able to claim that loss on your taxes, and you’ll get a break. You won’t be able to claim it all at once: you’re capped at $3,000 per year. But that capital loss deduction does roll over, year after year, until it is gone.
Could Selling to an Investor Create a Tax Benefit?
Most investors are going to make an offer on your home that is a little lower than fair market value. How much lower depends upon the condition of the home. If the home is in great shape, doesn’t need a single repair, is free of liens and gets through probate fairly quickly then our offer could be very close to your $300,000 basis.
This is rarely the case however. If your Aunt Maude is like most people, she left you a home that needs at least a little bit of work. That floor she always meant to get around to fixing, but never did. Or that water heater that’s on its last legs. The lien you knew nothing about. If that’s the case, then our offer might be considerably lower. We might only offer you $250,000 for such a home.
That means you take a capital loss, getting a break on your taxes. And while you may think, “yeah, but I just lost money!” the truth is, you might be saving money.
Just think about the repair costs you did not have to pay out of pocket (before seeing a single cent of the proceeds) to do the same thing an investor might do. It also means you’re not paying upkeep, utilities, homeowner’s association fees and vacant home insurance while you wait to get the home into tip-top shape.
Obviously, you should see our offer, talk to your accountant and think long and hard before making any decisions. These numbers do help you understand, however, why selling your inherited property to an investor might truly benefit you.