Fortunately, the recipe for inheriting a house can be a simple one. Of course, there are potential complications, but those belong in the alternative versions of this recipe for what to do when you inherit a house.
Ingrdients for a House Inheritance Finance Recipe
- Estate Taxes
- Capital Gains Taxes
- Property Taxes
- Selling
- Mortgages
- Legal Ownership
- Siblings or other co-beneficiaries
Taxes On an Inherited House
The first thing most people think of when they inherit a house is taxes. Between politicians running scare stories to boost their election chances, newspapers and financial news sources running edge-case scenarios with big, bold, headlines for clicks, or just those horror stories your less financially literate friends repeat, it can seem like the IRS is waiting to repel agents out of helicopters onto your parents’ old house to sieze it before you can set foot inside. The reality is, you probably won’t pay taxes on an inherited house at all.
Capital Gains and The Tax Basis
Before you start cooking up a tax avoidance scheme for the house you inherited, you need to know how the capital gains and tax basis ingredients work. The only taxes you, your parents, or great uncle, or anyone else, would pay on a house are capital gains taxes and property taxes.
Capital gains taxes can be complicated, but in this case, they are very simple. When you sell an asset, like a house, you pay capital gains taxes. A capital gain is the difference between the price you paid to aquire (buy) the asset –called the basis — and the price you get when you sell the asset. So, if mom and dad bought that 4-bedroom, craftsman, charmer in a good neighborhood with nice schools for $85,000 back in the 1960s, then their basis is $85,000. If they sold the house for $450,000 then their capital gain is $450,000 – $85,000 = $365,000. So, they would owe capital gains taxes on $365,000. Bummer, huh?
But wait!
First, there are all kinds of special rules that apply to real estate, including an exemption for $500,000 in capital gains taxes if your parents were filing a joint income tax return and it was their primary home for two of the last five years, so they wouldn’t pay any taxes on the sale at all. But, we aren’t here to talk about them, we are hear to talk about your inheritance.
The Step-Up Tax Basis
The step-up tax basis is the baking soda of your estate taxes recipe. It changes everything wherever you sprinkle it in. A step-up in tax basis means that the basis, that first ingredient in capital gains taxes, increases, or steps up to a higher amount. In this case, the home’s value on the day you inherit it.
So, in that example above where the basis in your parent’s house was $85,000? That number becomes whatever the fair market value of the house is on the date of inheritance. In other words, your basis in the home becomes $450,000. Now if you would like to do some sweet, sweet, tax math, the capital gains for your inherited property is $450,000 (your new basis) – $450,000 (the market value of the home) = $0 (zilch, zip, nada).
Inheritance Tax and the Death Tax
If you pay attention to the news, or worse, if you pay attention to politics, you have no doubt heard of the estate tax, inheritance tax, or death tax, depending upon who is talking. If you’re reading this blog for tax advice instead of talking to the family’s lawyer, chances are you won’t inherit anywhere near the amount of money necessary to trigger estate taxes.* Good news, though. This step-up in basis on inherited homes has nothing to do with that, so you owe zero taxes on mom and dad’s house.
I keep saying, “mom and dad,” just because that is the most common and I’m trying to be comforting and easy to read for the majority of readers. However, the step-up in real estate basis is for all inherited houses, not just those from parents. So, your great uncle you never met counts, the family friend that practically raised you counts, and everybody in between.
Property Taxes
Property taxes have nothing to do with you inheriting the property and a due to the state, or county, based upon a specific timeline that does not change with your inheritance. In other words, if property taxes in Colorado are due on Feburary 1st, then they are due on Feburary 1st for you as well, whether you inherited the home in September or on January 31st.
Many homeowners that have mortgages have their property taxes paid from an escrow account held by the mortgage lender. In most cases, you will either be entitled to the money from that escrow account, or in the case of inheriting on January 31st, the mortgage company may have already paid those taxes for you. Accrued property taxes are also often paid from the proceeds of a sale, so if you are selling the property and the taxes aren’t already late, you won’t have any issues.
The problem is when you inherit a property that has significant back taxes. In that case, you may have to work with the state or county to clear up the taxes before you can move forward.
Inheriting a House with a Mortgage
When you inherit a house with a mortgage, what happens next is up to the lender, and to a lesser extent how the property comes to you. First, and foremost, if you also happen to be executer of the estate, it is important that you continue to pay the mortgage out of the estate. Mortgage companies can, and do, impose late fees, start collections, and even foreclose on properties that are still in the estate of the decesed mortgage holder.
Before the house can be legally yours, you will need to deal with the mortgage company. Almost all mortgages come with a due now clause regarding ownership transfers. In other words, if you want to change the ownership of the home, you have to pay the mortgage company “now” or before you can assume ownership. This is not uncommon and happens thousands of times a day when the title company pays off the seller’s mortgage company “before” transferring the ownership of a home to the buyers.
However, this can be a lot stickier for someone who inherited a house and wants to keep the house, whether as an investment property, or as their primary residence. Theoretically, you can contact the mortgage company and ask to assume the mortgage. Don’t count on this happening. In most cases, the mortgage company will try and move you to a new mortgage in your name, even if they were willing to keep all of the other terms the same.
Of course, you can get a new mortgage, in which the new mortgage company will take care of that pesky “due now” clause before refinancing.
Legal Ownership
If you have already inherited property from a deceased benefactor, then it is too late for you to do much about how the transfer of legal ownership happens. Typically, the house will go through probate and distributed as described in the will. If there is no will, the probate court will decide what happens. Usually, they will give the house to the spouse, and if no spouse, then to the living children, but each state has its own rules and each case may have its own differing factors.
If you plan to inherit a house (or more specifically, if someone plans to leave you a home), it can make things a lot simpler if there is a trust to move the house on to its new owners without any sort of probate. A living trust is most common for this purpose, unless your parents (or other) are doing some advanced tax planning in which case an irrevocable trust may be put in place.
Inheriting a Home with Siblings or Others
Inheriting a home with others such as brothers and sisters or cousins, or whatever can be very complicated or very simple. If you inherit your parent’s home with your sister and the both of you plan to sell, then there shouldn’t be too many problems. If you inherit a home with your sister and you want to move in and she wants to sell it, then prepare to buy her out, or come up with some other arrangement. Whatever the case try and work together or the lawyers that get involved may cost more than the value of the house, not to mention the relationships you may lose along the way.
* The estate tax exemption for 2024 is $13.61 million, and $27.22 million for married couples. If you want to do a deep dive into estate taxes, start with IRS Form 706.