Inheriting property should feel like a blessing, not a tax headache. But the reality is more complicated than that. Washington doesn’t have a state income tax, which helps, but you’re still dealing with federal capital gains taxes when you sell inherited real estate. Understanding how to minimize what you owe can mean tens of thousands of dollars staying in your pocket instead of going to the IRS.
Understanding Step-Up In Basis
Here’s where things get interesting. The step-up in basis is probably the most valuable tax benefit you’ll ever get with inherited property. When you inherit real estate, the property’s tax basis resets to whatever it’s worth on the date the previous owner died. Let’s say your parents bought a house in Kirkland back in 1985 for $200,000. Fast forward to today, and it’s worth $800,000 when you inherit it. Your basis? It’s now $800,000, not the original purchase price. This matters enormously. If you sell that property shortly after inheriting it for $800,000, you won’t owe a dime in capital gains tax. There’s no gain to report. All that appreciation that happened during your parents’ ownership basically vanishes for tax purposes.
When Capital Gains Taxes Still Apply
You’ll face taxes if the property appreciates after you inherit it. Say you inherit that $800,000 house, but you don’t sell right away. Three years pass. Now you’re ready to sell, and you get $900,000 for it. You’re paying taxes on that $100,000 gain. How much you’ll pay depends on two things: how long you held the property and what you’re earning. The rates break down like this:
- Short-term capital gains (held less than one year): Taxed as ordinary income, which could hit you at rates up to 37%
- Long-term capital gains (held more than one year): Usually 0%, 15%, or 20% based on your income bracket
Working with a Kirkland tax planning lawyer helps you figure out the timing and which rate you’re actually facing.
The Primary Residence Exclusion Option
What if you moved into the inherited property yourself? That opens up a powerful option. If you make it your primary residence, you might qualify for the Section 121 exclusion. This lets you exclude up to $250,000 of capital gains if you’re single. Married couples filing jointly can exclude up to $500,000. There’s a catch, of course. You’ve got to live in the home for at least two of the five years before you sell. But if the inherited property has continued to appreciate significantly and you’re flexible about where you live, this strategy can be a game-changer. Some people save more in taxes with this approach than they’d make in salary over several years.
1031 Exchange Considerations
Maybe you want to turn the inherited property into a rental investment. That’s when a 1031 exchange becomes relevant. This lets you defer capital gains taxes by reinvesting the sale proceeds into another investment property. The rules are strict, though. Really strict. You’ve got 45 days to identify replacement property and 180 days to close on it. Miss those deadlines and the entire deal collapses. This approach makes sense if you want to stay in real estate investing but prefer a different property or location. Just remember that 1031 exchanges don’t eliminate taxes. They defer them. You’ll eventually pay when you sell without doing another exchange.
Coordinating With Estate Taxes
Washington has its own state estate tax that kicks in at $2.193 million for deaths in 2024. If the estate owed state estate tax, the property’s value was already reduced before it came to you. You don’t want to miscalculate and end up paying more than you should. The federal estate tax exemption sits much higher at $13.61 million for 2024. That’ll drop significantly in 2026 unless Congress changes course. A Kirkland tax planning lawyer can help coordinate all these calculations so you’re not leaving money on the table.
Timing The Sale Strategically
Selling in a year when your income is lower could drop you into a more favorable capital gains bracket. If you’re retiring soon or taking an extended time off work, that might be your window. Some families panic and sell inherited property immediately, assuming that’s always the smartest move. Sometimes it is. Other times, waiting makes far more financial sense. Can you take advantage of the primary residence exclusion? Would selling now push you into a higher tax bracket, or would waiting a few months not? These aren’t trivial questions. They’re worth thousands of dollars.
Getting Professional Guidance
Tax laws change constantly, and your specific situation involves variables that generic internet advice can’t address. Every inheritance is different. Eastside Estate Planning helps families understand their options when they’re dealing with inherited property and develop strategies that actually fit their financial goals. A personalized approach based on your circumstances will always save you more money than any cookie-cutter strategy you’ll find online.
