Selling an inherited home: how the capital gain is actually computed

The IRS publishes the arithmetic of a home sale as a short subtraction, and it is worth having in front of you before any of the rest of this makes sense.

• Selling price, less selling expenses, gives the amount realized.
• Amount realized, less adjusted basis, gives the gain — or the loss.

For an inherited home it is the second input doing the work. Basis is the fair market value of the property at the date of death, or at the alternate valuation date if the personal representative elected one. So the gain is not measured from what the person who died paid for the house decades ago. It is measured from what it was worth on the day they died.

Why selling early often leaves almost nothing to tax

Follow the two lines through. If a house is appraised at its date-of-death value and sells a few months later at roughly that value, the amount realized after selling expenses lands close to the basis, and the gain is small or negative. That is not a loophole or a strategy. It is simply what happens when the starting number has been reset to the value on the date of death and the market has not moved far since.

The corollary is the part people miss. Every year the property is held after the death, the distance between the date-of-death value and the eventual sale price is distance that can be taxed. A house kept for five years in a rising market and then sold produces a real gain, measured from the date of death, even though nobody in the family ever bought it.

Who reports the sale: the estate, or the heirs

This is not a matter of preference. It follows from who legally owns the property at the moment of the sale. If the estate is the legal owner and the personal representative sells the house during administration, the sale belongs on the estate's Form 1041, on Schedule D and Form 8949. If the property was transferred to the heirs first and they sold it, each of them reports their own share on their own return, on the same schedules.

Publication 559 is candid about the difficulty here: the personal representative may hold the legal authority to dispose of real property while title to it is vested in one or more beneficiaries, and the IRS points readers to local law to work out who the legal owner actually is. That is a state-law question sitting in the middle of a federal tax computation, which is exactly the kind of seam where returns go wrong.

Whether a loss is deductible depends on what the house was being used for

This distinction is among the least known and most consequential in the whole area, and Publication 559 sets it out for the estate's position in terms:

• Where the personal representative intends to realize the value of the house through a sale, the residence is a capital asset held for investment, and gain or loss on the sale is capital gain or loss — with the loss potentially deductible. Publication 559 says this holds even though the property was the decedent's personal residence, and even if it was never rented out.
• Where the house is instead not held for business or investment use — for example, a beneficiary is permitted to live in it rent free with a view to it being distributed to them — and it is later sold without first being converted to business or investment use, any gain is capital gain, but a loss is not deductible.

The same asymmetry exists for an individual selling their own home. Publication 523 puts it flatly: a loss on the sale of a main home cannot be deducted, though no tax is owed on the money received either.

The home-sale exclusion generally does not come with the house

This is the assumption that causes the most disappointment, and it is worth being precise about why it fails. The exclusion of gain on the sale of a main home is attached to the seller, not to the property. Publication 523 sets out the tests: ownership of the home for at least twenty-four months out of the five years leading up to the date of sale; use of it as a residence for at least twenty-four months of the previous five years; and a look-back requirement that the exclusion has not already been taken on another home sold within the previous two years.

An heir who inherits a house they have never lived in meets neither the ownership test nor the residence test at the moment they inherit it. The person who did meet them — the person who lived there for thirty years — has died, and the tests do not travel with the deed. For most heirs the calculation is therefore the plain one: gain measured against the stepped-up basis, with no exclusion in it.

Things that quietly move the number

• Selling expenses. They come off before basis is subtracted, so the costs of the sale are part of the computation rather than an afterthought to it.
• Improvements made after the death. Publication 523's rule is that improvements add to the value of the home, prolong its useful life, or adapt it to new uses, and their cost is added to basis. Ordinary maintenance and repairs are not treated the same way.
• Any rental history. If the home was rented at some point, depreciation taken during that period changes the calculation and brings its own recapture rules with it.
• Fractional interests. Where several heirs each hold a share, each reports their own share of the gain, measured against their own share of the basis.

The last word belongs to someone holding your numbers

The mechanism above is stable and public: basis set at the date of death, subtracted from the amount realized; long-term treatment whatever the holding period; no main-home exclusion for a seller who never lived there. What is not stable is how that mechanism behaves once a trust, a fractional interest, a rental period or several co-owners are involved. That is a conversation with a CPA or an enrolled agent, with the appraisal and the closing statement on the table between you.