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Income Tax Law: Reporting Sale of Inherited Real Property

Special income tax law rules for inherited out-of-state real property

Follow the Rules or Else…

Income tax law strikes fear in the hearts of Americans. The reason is simple. Income tax law is confusing. And the consequences of misinterpreting income tax law  (whether intentional or not) can be dramatic, ranging from lost fortunes in tax penalties to prison sentences for tax evasion. No one’s immune from Uncle Sam’s reach. Former Vice President Spiro T. Agnew, notorious gangster, Al Capone, and pop-cult movie icon, Wesley T. Snipes are just some of the many infamous income tax law abuse cases in the last century. What does this mean for you? Absolutely nothing. At least not right now. You’ve been paying the appropriate income taxes each year so you’re not in danger of a “Major League” disaster. But what happens when Dad leaves you the rustic ski cabin in Jackson Hole, Wyoming. Or you inherit Uncle Johnny’s beach cottage in the Hamptons. A commonly confused income tax law concept deals with reporting a gain or loss on sale of out-of-state inherited real property. Do you now owe taxes in other states? How and where do you file a return? Inheriting real property located out-of-state carries special income tax law considerations.

Special Income Tax Law Rules for Inherited Property

Al Capone is just one of the many famous people who failed to follow the income tax law rules Inherited assets are treated differently than other capital assets under income tax law. Comprehension of these differences will help you to plan and potentially minimize your tax impact.

Short-Term vs. Long Term

Normally, capital assets sold within a year of “acquisition” are short term. Those held  longer than a year are long-term. Inherited assets are automatically considered “long-term” even if sold within 1 year of “death.” The characterization of inherited property as “long term” necessitates that you report it on Schedule D (long-term) of your tax return.

Fair Market Value Determination

When a capital asset is sold (such as real estate), the difference between what you sell it for and the “basis” (usually what you bought it for) is either a capital gain or capital loss. The basis for inherited property under income tax law is the value of the property on the date of death.

Case Example

Harry Husband and Wanda Wife, California residents, inherit real property located in Texas from Harry’s mother, Mona, in January 2010. Mona’s bought the property with her late husband in 1925 for $10,000. The fair market value of the property at the time of inheritance is $500,000. Harry and Wanda, Niner’s season ticket holders, never leave the Golden State to live in the inherited Texas home. Harry and Wanda make no improvements on the home other than minor maintenance and upkeep. They sell the home 6 months later in July 2010 for $470,000.

  • Do Harry and Wanda need to file a tax return with the Feds? Yes. They need to file a Federal Tax return to report the “long-term” capital loss.
  • How much do they need to report? $30,000.00. Harry and Wanda inherited the property. The measuring point to determine gain or loss is the difference between what the property is sold for ($470,000) and the fair market value on time of inheritance ($500,000).
    • Harry and Wanda don’t inherit Mona’s tax basis of $10,000. If the income tax law rules were as such, they would incur a $460,000 gain on sale of the real property ($470,000 – $10,000). Phew..! Thank-you Mr. Tax Man.
  • Do they need to file in California? Yes. They need to file a California tax return because California taxes its residents on worldwide income.
    • If the state where they inherited the property has income tax, then credit is allowed for the tax on the California return.

Moral of the story. Income tax law rules are confusing and change depending on your circumstances. If you’ve inherited property, you need to report it to the Feds, California, and potentially the out-of-state tax authorities.

About Dan Hanley

Specializing in estate planning, elder law and real estate law, Dan brings a wealth of experience and knowledge to help his clients with a variety of legal needs. In addition to a MBA and Juris Doctorate from Santa Clara University, Dan is also a licensed real estate broker since 1980.

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