Capital Gains When Selling an Inherited House

The Short Answer: Inherited Property and Capital Gains

When someone inherits a California house and sells it, capital gain is generally measured from the home's fair market value on the date of death, not from what the person who died paid for it. Federal law resets that starting point, so usually only the change in value after the death is taxable gain.

Most people facing this question have just inherited a parent's or spouse's house, or have been named executor or successor trustee, and are trying to decide whether to sell. Brothers and sisters may already be asking what a sale would leave after taxes. Someone may remember that the house was bought for a fraction of what it is worth now and worry that the whole difference will be taxed. This page explains what "basis" means, how the stepped-up basis rule works, how the date-of-death value is defined and reported, and how gain is figured when the house sells. It closes with the questions that usually turn on the facts of a particular estate.

What 'Basis' Means and Why It Matters for an Inherited House

Basis is the dollar figure used to measure gain or loss when property is sold. For a house someone buys, basis generally starts with the purchase price. Adjusted basis is that starting figure after changes. It is generally raised by capital improvements and lowered by depreciation if the property was ever rented out.

An inherited house starts from a different place. A buyer's basis comes from what the buyer paid. An heir paid nothing, so the law sets the heir's starting basis by reference to the date of death instead. What the person who died paid decades ago generally drops out of the calculation.

That matters for one reason: basis decides the size of the taxable gain. A higher basis means a smaller gain, or a loss, when the house sells. A lower basis means a larger gain. For a family weighing a sale, knowing the basis is often the first step to seeing what a sale actually means for each person.

The Stepped-Up Basis Rule Under Federal Law

Federal law sets the heir's basis. Under 26 U.S.C. § 1014(a), the basis of property acquired from a person who died is generally "the fair market value of the property at the date of the decedent's death." Other subparagraphs of that section allow an alternate valuation date when the estate elects it, and special values for certain farm property and conservation easements.

The practical effect is the "step-up." A house bought long ago that rose in value takes on its date-of-death value as the heir's basis. The IRS notes on its Frequently asked questions on estate taxes page that "there is usually little or no gain to account for if the sale occurs soon after the date of death."

The rule covers property acquired by inheritance, through the estate, or from a revocable trust the decedent controlled until death, under 26 U.S.C. § 1014(b). The same IRS page reminds readers that "the rules are different for determining the basis of property received as a lifetime gift." And under 26 U.S.C. § 1014(e), if an heir or the heir's spouse gave appreciated property to the decedent within one year before the death and it comes back to that donor, the basis is generally the decedent's own adjusted basis instead.

How the Date-of-Death Value Is Defined and Reported

Fair market value is, in the words the IRS quotes on its Frequently asked questions on estate taxes page, "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell." It is the value on that day, not the original price and not today's price.

When an estate files a federal estate tax return (Form 706), IRS Publication 551, Basis of Assets says beneficiaries generally receive a Schedule A (Form 8971) reporting the estate tax value, and certain beneficiaries must use that value as their starting basis, consistent with 26 U.S.C. § 1014(f). Whether a return is required is a question for a CPA or tax attorney. California income tax treatment is administered by the Franchise Tax Board, which publishes its own guidance on basis.

How Capital Gain Is Calculated When the House Sells

The arithmetic itself is simple. Under 26 U.S.C. § 1001(a), gain is "the excess of the amount realized" over the adjusted basis, and a loss is the reverse. Under 26 U.S.C. § 1001(b), the amount realized is the money received plus the fair market value of any other property received.

Put together, the calculation runs in three steps:

1. Start with the heir's basis, generally the date-of-death value.
2. Adjust it, generally upward for capital improvements and downward for any depreciation.
3. Compare that adjusted basis with the amount realized on the sale. The difference is the gain or the loss.

Because the starting point is the date-of-death value, the gain usually reflects only what happened to the house's value after the death.

Questions That Depend on the Specific Estate

Several questions families often raise turn on the facts of a particular estate and are usually worked through with a CPA or tax attorney. They include how long the heir is treated as having held the house, whether a home-sale exclusion has any role, how the way the house was titled in California affects the result, how the numbers work when several heirs share the house, and how the date-of-death value is established in practice. On title, one federal rule stands out: for a house held as community property, 26 U.S.C. § 1014(b)(6) treats the surviving spouse's one-half share as property acquired from the decedent as well, if at least one-half of the whole community interest was includible in the decedent's gross estate, so that half too generally takes its basis from the date-of-death value. The basis rules above are the common starting point for each of them.

Talking Through an Inherited House

Families deciding whether to sell an inherited California house often find it useful to talk through basis, title and the estate's paperwork before a sale.