How to pay less tax when you inherit real estate

ATLANTA (FOX 5 Atlanta) - Inheriting real estate can be a great thing, but those involved need to know what Uncle Sam has to say about it.

Recently, a Good Day Atlanta viewer sent us an email with an important real estate question:

FOX 5 real estate expert John Adams joined Good Day to answer all your questions about this tricky tax issues.

Q: What tax do you have to pay when you inherit real estate from a family member who passed away?

A:  When inheriting real property, the beneficiary inherits the property at a "stepped-up" basis. That means that if they decide to sell the property quickly after they inherit it, they would have no tax due. 

Obviously, if there is a mortgage on the property, they’d have to pay that off at closing, but there would be no income tax due on the sale.

Q: What does "basis" mean when it comes to real estate?

A: Your basis in a property is how much you paid for it when you acquired it, plus any major improvements a homeowner has made over the years. Those are called capital improvements, So, for example, if the owner of the home replaced the HVAC system on a rental home, that would add that amount to their basis.

There are specific rules for determining that basis, and it would be wise for you to familiarize yourself with them. You want the new basis to be as high as possible, so that your current capital is minimized.

Q:  The viewer apparently inherited the house from his dad, then rented it for 15 years, and recently sold it. What happens then?

A: When a beneficiary inherits property from a decedent, the asset receives a step-up in basis to its value on the date of death – which is both a tax perk for inheritors, and a form of tax simplification (as beneficiaries otherwise may not know what the decedent’s original cost basis was anyway).

The actual question behind the question to John Adams was how much was the house worth when I inherited it in 2004? Because if he just sold it for anything more than the stepped-up basis in 2004, he must report that “profit” as a capital gain and pay tax on it.

Q:  So it’s 2019!  How can we possibly figure out what the house was worth when the viewer inherited it from his dad?

A:  Probably the easiest way to establish a reasonable value on the date of death of the decedent is to find out the county tax assessment for that calendar year.  

The courts do not presume that you are an expert in property valuation, and it is reasonable to rely on the county valuation because they are required, under state law, to evaluate the property and establish a value for property-tax purposes.  

However, assessed values typically are slightly below actual market value, especially in 2004, which is pre-recession (meaning values were rising).

Q:  Is there any way to actually know what it was worth on the date of death?

A:  Establishing an exact value is an art as well as a science. Yes, we can estimate value as of a certain date, but we can never be sure because the house was not actually sold on that day.

Q: Can you hire an appraiser?

A: Yes. If you want to spend $500 or so, you can order a forensic appraisal as of a certain date.  Some appraisers specialize in "backward-looking" appraisals for a variety of purposes, including the establishment of basis for inheritance purposes.  

John Adams' guess is that any savings would not exceed the cost of the appraisal, but he admits he could certainly be wrong.

Q:  So, does that cover the topic?

A:  Yes and no. Yes, we have covered the main points of the topic, but no, we didn’t cover everything!

We never even mention recapture of the depreciation of the improvement, which is mandatory on rental property.

As you can imagine, the IRS has made this a confusing topic, with lots of special rules and regulations.  That’s why John Adams' bottom-line recommendation to anyone lucky enough to inherit real estate is to work with a CPA who is experienced in handling income taxation on real property.