Inheriting Property: Navigating the Maze of Inheritance Tax

Whether it’s a cherished family home, vacation house, or a portfolio of investment properties, inheriting property often precipitates unexpected financial responsibilities. Understanding the nuances of estate and inheritance tax well in advance of property acquisition is essential to mitigate potential financial burdens.

Too often, estate planning can be an afterthought, prompting a complex and stressful transition for heirs. Inheriting property can introduce legal obstacles, potential tax implications, and family differences that can have an impact on heirs. By laying the groundwork now, you will be better positioned to navigate the process, strategically protect your interests, and ensure a smoother transition for all those involved.

Financial Obligations When Inheriting Real Estate

At the outset, heirs could be faced with a number of financial obligations and decisions to make before selling the property or changing the deed. Outstanding mortgages or unpaid taxes attached to the property must be settled before the property can be sold. While most debts are typically settled from the estate, there are exceptions where an heir may be personally liable for inherited property, including if they:

• Co-signed on a loan
• Are the surviving spouse in a community property state (applicable to married couples in Arizona)
• Are subject to state filial responsibility law (not applicable in Arizona)
• Decide to keep the home and assume a mortgage or home equity loan

Further, when multiple individuals inherit a property, consensus-building among heirs becomes critical in determining the future of the property. They must decide whether to keep or sell the property, invest in any necessary repairs, and what market price they are willing to accept.

Openly discussing these options and crafting a plan before the time comes will help prepare heirs to manage their financial responsibilities and make more informed decisions.

Tax Liability on Inherited Property

Beyond the inheritance itself, there are four main types of taxes that may apply to real estate property: estate tax, inheritance tax, capital gains tax, and income tax.

Estate Tax

The estate tax is a federal tax on the transfer of property to an heir after the owner’s passing. Currently, the federal estate and lifetime gift tax exemption rate in 2024 is $13.61 million, with tax rates ranging from 18% to 40%, depending on the size of the estate. The exemption amount, however, is slated to sunset at the end of 2025, dropping back down to the prior Tax Cuts and Jobs Act level of $5 million, adjusted for inflation.

While estate tax is imposed directly onto the estate itself—not the beneficiaries—inheritance typically will be received after the estate tax is settled. This does not preclude the implementation of strategic estate planning measures prior to the decedent’s passing, which can significantly mitigate the tax burden and optimize the distribution of assets to heirs. Now is a good time to consider implementing tax planning strategies should your estate reach beyond the anticipated inflation adjusted $5 million threshold after 2025.

In addition to federal estate tax, twelve states and the District of Columbia impose their own estate taxes. Luckily, both residents and nonresidents who own property in Arizona are exempt from state estate taxes, providing a favorable tax environment for property transfer.

Inheritance Tax

For federal and Arizona tax purposes, an inheritance is not considered taxable income. Unlike the estate tax, however, inheritance tax is passed on to the beneficiaries of the inheritance, not the estate. This means that an heir may be subject to inheritance tax if the property is located outside of Arizona. For example, states like Maryland, Pennsylvania, and Nebraska have inheritance tax that applies to out-of-state heirs.

Capital Gains Tax

Another tax consideration for inherited property relates to the potential for capital gains. While the initial inheritance is often tax-free, the disposition of inherited assets can trigger capital gains tax if sold for a profit. However, heirs often benefit from the stepped-up basis, which revalues the inherited asset to its fair market value at the time of the owner’s passing, potentially reducing the taxable gain to zero upon a sale.

To minimize or eliminate capital gains tax on inherited property, consider the following:

• The stepped-up basis amount is determined based on the fair market value of the property at the date of death of the previous owner.   An appraisal may be necessary to determine and document this amount, so it is essential you consult with the personal representative of the estate and your own tax and legal advisors to determine what needs to be done.
• Implement the Section 121 Exclusion, which allows up to $250,000 ($500,00 for joint returns) of the capital gain to be excluded from the sale if the heir resides in the property as their primary residence for at least two of the five years preceding the sale.
• Consider a 1031 like-kind exchange, allowing heirs to sell the inherited real property and reinvest the profits into a similar property without incurring capital gains tax. To learn more about tax-efficient real estate investing strategies, including Real Estate Investment Trusts (REITs), check out our blog on Understanding REITs: A Guide to Tax-Efficient Real Estate Investing.
• Deduct the selling expenses from the sale price to reduce overall capital gain.

While these strategies offer a general starting point, individual circumstances shape the tax planning process and require a customized approach to optimize outcomes.

Income Tax

While inheritance itself is generally not considered taxable income, the income generated from inherited assets can be subject to taxation. This includes any income produced through investment properties such as long-term or vacation rentals.

Prior to distributing the inherited assets, the estate must file two separate income tax returns: a final income tax return for the deceased individual, accounting for income earned up until the date of death and an estate income tax return to report income generated by the estate’s assets from the date of death through the date of distribution to the heirs.

Consider Forming a Trust

Trusts offer a strategic approach to estate planning. By transferring assets into a trust, heirs can bypass the often time-consuming and costly probate process upon their passing. Trusts can provide greater control over asset distribution and can be structured to minimize estate taxes. While revocable trusts allow for asset accessibility during the grantor’s lifetime, irrevocable trusts offer more robust estate tax benefits, although their assets are typically tied up until the grantor passes away.

Remember, while it may seem advantageous to establish joint ownership with heirs, it will inadvertently increase their tax liability because only a portion of the asset will be eligible for the step-up in cost basis. Further, for long-held property, this could result in a sizeable deferred capital gains tax liability for the heir.

Next Steps

Tax laws change often, so it’s important to stay informed on federal and state regulations to ensure existing estate plans are optimized and compliant with current law.

If you are anticipating an inheritance or planning your estate, R&A can help. We’ll work with your family’s team of trusted advisors to help you implement a comprehensive plan for your estate.