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Understanding what happens when you inherit a house, as well as addressing the tough financial and emotional decisions on what to do with the home, can be intimidating.
This guide will explain what happens when you inherit a home and help you navigate the tax implications, legal and financial responsibilities, and the process of choosing what to do with your newly inherited house.
What to consider when you inherit a house
When you inherit a house, you need to consider these three things:
- The financial and legal responsibilities of the inherited home, including debt obligations.
- The tax liabilities of the inherited home, including federal estate taxes or capital gains.
- What you'll do with the home, which could include moving into it, renting it out, or selling it.
All three of these relate to each other. For most people, deciding what to do with the inherited property is based on the financial and legal responsibilities relating to the home, which in turn impacts how you're taxed.
Let's discuss the three considerations and the related responsibilities—both financial and legal.
Tax implications: Do I have to pay taxes on an inherited home?
If you inherit property, you may wonder if you're responsible for paying taxes. Luckily, there's no federal inheritance tax, although some states do have inheritance taxes. But for most people, inheriting property doesn't trigger an immediate tax liability.
When a property is inherited, the IRS establishes a fair market value (FMV), which is the new basis for the property. This is called a step-up basis. This new valuation influences future taxes when the property sells.
Capital gains are a special type of tax relating to the profit generated by an asset, such as a house. The step up in basis means you're only subject to capital gains taxes if you sell the home. You'll pay taxes on the difference between the established fair market value at the time of inheritance and the selling price.
If your parents originally bought the home in the '80s for $30,000, but its FMV is $400,000, your new tax basis is $400,000. If you sell the property for $400,000 shortly after inheriting it, you wouldn't be subject to any capital gains taxes because there's no profit. However, if you sell the property for $425,000, you'd pay capital gains tax on the $25,000 profit.
If you keep the home, you may be eligible for a capital gains exclusion. According to the IRS, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse, if you meet two conditions:
- You use the home as a primary residence for at least two years out of a five-year period.
- You haven't used the capital gains exclusion on another residence in the two-year period before the sale.
Financial and legal responsibilities of inheriting a house
Inheriting a home can be a blessing or a burden, depending on several factors:
- The existing debt obligations, such as a mortgage
- The current condition of the property
- The costs of ongoing maintenance and upkeep
- If there are multiple heirs
Does the inherited property have an open mortgage?
If the property has an open mortgage, it's important to discern the type of mortgage and whether it's due on sale or assumable. Most mortgages can be assumed by the mortgagor's heirs, meaning the heirs take over payments and pay the remaining debt according to the original loan terms.
However, some loans, like reverse mortgages, specifically state that the unpaid balance is due on sale or when the mortgagor passes, requiring the heirs to sell the home to settle the debt.
What is the condition of the property?
The condition of an inherited property often impacts what the heirs decide to do with it. If the property hasn't been maintained, it could need costly and time-consuming improvements. Coordinating a small- or large-scale renovation is a big task and should be carefully considered before deciding whether to keep the home or sell it.
Additionally, the heirs are now responsible for paying taxes, insuring the property, and maintaining it on an ongoing basis. For some, these responsibilities are too large of a burden -- in this case, it may be easier to sell the home as-is. For others, it may make sense to fix up the home and keep it.
If you inherited a house with your siblings
It's fairly common for multiple siblings or family members to share ownership of an inherited house. For some families, this isn't an issue. For others, having multiple heirs complicates things because each person has different needs and opinions. One sibling may prefer to sell the home for cash now, while another would prefer renting it for long-term income. One sibling may even want to move into the house.
The number of people sharing ownership and how they communicate and interact with each other often plays a large role in what's done with the property.
Moving into the house
One option when inheriting a home is making it your primary residence. If you want to move into a house with an outstanding mortgage, determine whether the debt obligation on the home makes financial sense. The mortgage balance may be more than the home is worth, the principal and interest payment (P&I) may be more than you can afford, or the ongoing maintenance (including property taxes and insurance) could be too high. Consider the cost of keeping the home before moving into it.
If there are no debt obligations and the home is owned free and clear, moving into it can let you sell your old primary residence and live in the new home debt-free. This is a great way to keep the home in your family, letting you make new memories where many good times were shared before.
If there are multiple heirs sharing ownership in the house, deciding who will move into the home can be challenging. For most, this option makes the most sense when only one person inherits the property.
Tax implications of keeping the home
Moving into the home has the least effect on your taxes overall, especially if you can take advantage of the capital gains exclusion when you sell the home in the future.
Financial and legal responsibilities of keeping the home
When you move into an inherited home, you're responsible for repaying any debt, maintaining the property, paying taxes and property insurance, and all other financial and legal responsibilities for the home.
Selling the house
As difficult as it may be, sometimes the best option is to sell the home -- especially if multiple heirs now share ownership. This can provide cash immediately and remove legal and financial responsibility related to owning the home.
While you may be able to sell the home for a profit, you need to take into account the costs associated with the sale of the home, which can include:
- any outstanding debt obligations, such as a mortgage, that need to be paid;
- the cost to fix up the home to get it ready to sell for top dollar;
- closing costs and fees; and
- real estate agent commissions.
Tax implications of selling the home
Selling the home has the largest tax implication. If there's a profit on the sale of the home from the tax basis at the time of inheritance, you could be responsible for paying short-term or long-term capital gains tax, depending on how long you held the property.
Financial and legal responsibilities of selling the home
Once the property is sold, you're no longer responsible for maintaining it, paying taxes, having insurance, or any other legalities of homeownership.
Renting the house
The last option available if you inherit a house is to keep it as a rental property. This option may be appealing to those who have some experience in real estate and understand the obligations of owning a rental property. However, being a landlord isn't always easy. While it can be a nice way to produce passive income or cash flow, it does come with responsibilities.
Tax implications of renting the home
Since the home isn't being used as a primary residence, it's not eligible for capital gains exclusion when you sell it in the future. However, several tax advantages come with owning rental properties, including the option to deduct certain expenses related to owning them. Earned income from a rental is also taxed at a lower rate than ordinary income, which may increase your overall income without moving you into the next tax bracket.
Financial and legal responsibilities of renting the home
In addition to the normal legal and financial responsibilities of owning a home, you now have the additional responsibilities of being a landlord. While you can outsource some of these roles to a third-party management company, you should seriously consider the additional responsibilities and liability of renting the home.
As overwhelming as it may feel when you inherit a property, understanding what happens when you inherit a house is a big step in the right direction. Take the process step by step and speak with a licensed accountant or attorney about your options to determine how the inheritance will affect you or your family.
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