Although an inheritance can be considered a prize, Uncle Sam can’t be left out of the equation. No one likes paying taxes, but they must be taken into account anytime a financial decision is made.
That said, you won’t need to pay the kind of taxes you currently do for the home you currently live in. The amount of taxes you owe will be determined by several aspects. To learn what your next step will be, you must learn about essential terminology.
Capital Gains Tax vs. Income Tax
Most people spend most of their lives handling income taxes alone. Income tax is a tax placed on all revenue sources: tips, wages, and self-employment earnings. At times, prize money or debt forgiveness can be placed on your income tax.
Capital gains tax is a tax placed on asset’s sale, like bonds, stocks, or property.
Fortunately, the rate of capital gains taxes are not as high as the rate for income tax. Based on your tax bracket, income tax begins at 10% and can go up to as high as 39.4%. Capital gains tax won’t ever exceed 15%, and 0% is paid on the lowest two capital gains tax brackets.
Click here to locate your tax bracket.
Why is it such a surprise for people to learn that they must pay taxes on capital gains? This is due to many people being ignorant of such figures. Assuming you’re not self-employed, your employers pay half of your tax. The remainder is taken from your paycheck. The amount leftover is yours to use as you see fit, and some people even receive a refund at year’s end.
However, no one is paying or matching your capital gains tax, so if there is an amount owing on your end, it will need to be paid out of your own pocket. If you’re not prepared to do so, you can anticipate receiving a sizeable tax bill in the near future.
Thankfully, you won’t be taxed on the entire amount the home is sold for.
The “basis” of the property is the amount that the IRS uses to establish whether you have a capital gain or loss. “Basis” represents the value of your home with regards to taxes.
The main homeowner basis is determined by using the property’s original sale price and adding the price of all enhancements. For instance, if you purchased your property for $200,000 and added $30,000 for a metal roof three years later, your basis would be $230,000.
That said, when a property is inherited, the basis is determined another way. Rather than attempting to find all the repairs made or using sales data that might be outdated, the IRS uses the property’s Market Value on the date of the decedent passed away.
This is to your benefit. Uncle Ben might have paid $100,000 for her three bedroom, 2-bathroom house in the 1970s. Let’s say he passes away in 2017 and you want the IRS to refrain from using $100,000 in addition to the $10,000 he paid to have his kitchen renovated. That home could sell for $110,000 nowadays meaning you would need to pay unbalanced capital gains on the property. But the IRS will see the value of the home as $110,000 when determining if you have produced a loss or gain.
If a gain is generated on your end, it is taxable. If you produce a loss, it is tax deductible. It is prudent to keep this in mind as you consider your next actions.
Determining Loss or Gain
Determining if you’ve produced a loss or gain is easy.
Using Uncle Ben’s property as an example once more, with a basis of $110,000, and you’re the sole heir. The home is sold for $200,000. You’ve produced a capital gain of $90,000. You’ll owe $9,000 in capital gains tax if you’re in a 10% tax bracket. This might be okay if you are mindful of putting away the $9,000 prior to spending any of it, but you’re in for a rude awakening if not!
That said, if the home is sold for $100,000, then you’ve endured a $10,000 capital loss. On your taxes, that loss can be claimed, and you’ll receive a break. The entire amount can’t be claimed at one time: there is an annual cap of $3,000. However, that capital loss deduction does roll over every year until it’s gone.
Could a Tax Benefit Be Created by Selling to an Investor?
Many investors will make you an offer for your property that is below fair market value. The number is based on the home’s condition. If the place is in good shape, doesn’t warrant repairs, has no liens placed on it, and goes through probate fast enough, then our offer may be near your $150,000 basis.
This is not always the outcome, though. If your Uncle Ben is like others, he left behind a property for you that warrants some work: the floor he intended to get fixed but didn’t get a chance to…the water tank is severely outdated…there is a lien on the property you weren’t aware of…if any of these instances sound familiar, our offer may be more economical.
We may only offer you $80,000 for that kind of property. Therefore, you would receive a break on your taxes by taking a capital loss. You’ll receive a cash check for $80,000. Although you might only see the $50,000 loss, the reality is that you would be saving money.
If we gave you $80,000, it’s because we believe it will take $50,000, give or take, to restore the home into a sellable property. That’s $50,000 that didn’t come out of your bank account (prior to seeing any of the proceeds) to do the same work. Additionally, it means you’re not maintaining the home, covering upkeep, or paying utility bills, vacant home insurance, and homeowner’s association fees while waiting for the home to be fixed up.
It’s worthwhile to consider our offer, speak with your accountant and take the time to go over the pros and cons of the decision you make. These figures help you learn more about how you may benefit from selling an inherited home to an investor.