How to Avoid Capital Gains Tax on Inherited Property: Complete 2026 Guide
Seven strategies to minimize or eliminate capital gains tax when selling property you inherited, from step-up basis to 1031 exchanges.
By Trevor SybertzPartner at Anchor1031
Key Takeaway
Many investors who inherit property use strategies like leveraging the step-up in basis, which can eliminate decades of appreciation from tax calculations, combined with strategic timing or considering a 1031 exchange for investment properties. According to Anchor1031, for heirs who inherit rental property but do not want landlord responsibilities, Delaware Statutory Trusts (DSTs) offer a way to defer taxes while transitioning to passive ownership.
Individual tax situations vary. Consult your CPA to evaluate which strategy is appropriate for your circumstances.
Inheriting property can be both a blessing and a tax planning challenge. Many people assume they will face a large capital gains tax bill when selling inherited real estate, but the reality is more favorable than you might expect. The IRS provides powerful provisions that can significantly reduce or even eliminate capital gains taxes on inherited property.
This guide covers seven strategies that heirs use to minimize their tax burden when selling inherited property. Understanding the step-up in basis rule is essential, as it forms the foundation for most inherited property tax planning. From there, you can layer additional strategies like 1031 exchanges and Section 121 exclusions depending on your situation.
Understanding How Inherited Property is Taxed
Before exploring avoidance strategies, it is important to understand the tax rules that apply to inherited property. The good news is that inherited property receives special treatment under the tax code that benefits heirs significantly.
What Makes Inherited Property Different
No Income Tax on Inheritance: In general, receiving inherited property is not considered a taxable event for federal income tax purposes. The act of inheriting real estate typically does not trigger an immediate tax liability. Tax implications generally arise when the property is later sold.
Capital Gains on Sale: When you sell inherited property, you may owe capital gains tax on the difference between the sale price and your "basis" in the property. However, inherited property has a significant advantage: the step-up in basis.
The Step-Up in Basis Explained
Under IRC Section 1014, when you inherit property, your tax basis is "stepped up" to the property's fair market value on the date of the original owner's death. This is one of the most valuable tax benefits in the entire Internal Revenue Code.
Example: The Power of Step-Up Basis
Consider this scenario:
Your parent bought a home in 1985 for $75,000
Property value at parent's death (2025): $450,000
Your stepped-up basis: $450,000 (NOT $75,000)
You sell for $460,000 six months later
Taxable gain: Only $10,000
Without the step-up in basis, you would owe capital gains tax on $385,000 ($460,000 minus $75,000). At a 20% rate plus the 3.8% NIIT, that would be approximately $91,630 in federal taxes alone.
This example is for illustration only. Consult your CPA for calculations specific to your situation.
When Capital Gains Tax May Apply
Capital gains tax generally applies only to appreciation that occurs after inheriting the property. For example, if the property value increases from $450,000 (the stepped-up basis) to $500,000 by the time of sale, the taxable gain would typically be $50,000, not the entire appreciation from the original purchase.
Under current tax law, inherited property is generally treated as long-term capital gain regardless of the holding period after inheritance. This treatment typically qualifies the gain for long-term capital gains tax rates of 0%, 15%, or 20% based on income level. Consult your CPA to calculate your specific tax liability based on your circumstances.
Strategy #1: Consider Selling Soon After Inheriting
One common approach to minimizing capital gains tax on inherited property is selling relatively soon after inheritance. Since the basis is stepped up to fair market value at the date of death, a sale shortly thereafter typically means there is limited time for additional taxable appreciation to accrue.
Why Timing Matters
If you inherit property worth $500,000 and sell it for $505,000 three months later, your taxable gain is only $5,000. At a 15% capital gains rate, you would owe approximately $750 in federal taxes. Compare that to waiting several years while the property appreciates another $100,000, which would result in approximately $15,000 in taxes. Consult your CPA to evaluate timing strategies for your specific situation.
Strategy #2: Option to Convert to Your Primary Residence
Section 121 of the Internal Revenue Code provides an exclusion of up to $250,000 of capital gains ($500,000 for married couples filing jointly) on the sale of a primary residence. For inherited property, this exclusion may become available if the heir converts the property to their primary residence.
Requirements
Under Section 121, qualifying for the exclusion generally requires ownership of the property for at least two years and use as a primary residence for at least two of the five years before selling. The ownership and use periods do not need to be continuous or overlap. Consult your CPA to determine if you meet the requirements for this exclusion.
Example Calculation
Stepped-up basis: $400,000
Move in and live there for 3 years
Sell for $650,000
Capital gain: $250,000
Section 121 exclusion: $250,000
Taxable gain: $0
This strategy works best when the inherited property is in an area where you want to live and the expected appreciation makes the two-year residency worthwhile. Note that qualification requires actually moving in and making it your primary home, not just claiming it as such. Consult your tax advisor to determine if this strategy is appropriate for your situation.
Strategy #3: Using a 1031 Exchange for Inherited Investment Property
If you inherit rental property, commercial real estate, or vacant land held for investment, you can use a 1031 exchange to defer capital gains by reinvesting into another like-kind investment property.
When 1031 Exchange Applies to Inherited Property
The property must be held for investment or business use, not personal use. If you inherit a property that was used as a rental by the decedent, it typically already qualifies. If you inherit a home that was the decedent's primary residence, you would need to convert it to rental use first and hold it as an investment for a reasonable period (typically 12-24 months) to establish investment intent. Consult your tax advisor to determine the appropriate holding period for your circumstances.
Why DST Investments Are Ideal for Inherited Property
For heirs who inherit rental property but do not want landlord responsibilities, Delaware Statutory Trusts (DSTs) offer a compelling solution. A DST allows you to complete a 1031 exchange into professionally managed, institutional-quality real estate while eliminating property management duties.
Strategy #4: Consider Offsetting Gains with Capital Losses
Investment losses in stocks, bonds, or other assets may be used to offset capital gains from inherited property. This strategy, commonly known as tax-loss harvesting, can potentially reduce or eliminate capital gains tax liability when losses are available. The IRS generally allows capital losses to offset capital gains on a dollar-for-dollar basis.
How It Works
Capital losses offset capital gains first. If you have $50,000 in gains from selling inherited property and $50,000 in losses from selling stocks, your net taxable gain is zero. Excess losses beyond your gains can offset up to $3,000 of ordinary income per year, with remaining losses carried forward.
Plan strategically by reviewing your portfolio before selling inherited property. If you have positions with embedded losses, consider selling them in the same tax year to offset the gain. Consult your tax advisor before implementing a tax-loss harvesting strategy.
Strategy #5: Document Improvements and Selling Costs
Capital improvements made to inherited property generally increase your cost basis, which can reduce taxable gain when you sell. Selling expenses, while they don't add to basis, are typically deducted from sale proceeds when calculating gain, which also reduces the taxable amount.
Items That May Reduce Taxable Gain
Capital Improvements (Add to Basis)
New roof, HVAC replacement, kitchen remodel, room additions, major structural repairs
Selling Expenses (Reduce Proceeds)
Real estate commissions, closing costs, legal fees, title insurance, transfer taxes
Example Calculation
Stepped-up basis: $400,000
Improvements made: $30,000
Adjusted basis: $430,000
Sale price: $500,000
Less selling costs: $35,000
Net proceeds: $465,000
Taxable gain: $35,000 (not $100,000)
Strategy #6: Consider Charitable Donation
Donating inherited property to a qualified charity may allow heirs to avoid capital gains tax while potentially receiving a charitable deduction for the property's fair market value. Under IRS rules, donations of appreciated property to qualified charities are generally not subject to capital gains tax.
Charitable Remainder Trust Option
A Charitable Remainder Trust (CRT) is a tax-advantaged structure that allows the donor to transfer property to the trust, receive an income stream for a specified period or for life, with the remainder eventually going to charity. This approach may provide partial tax benefits while maintaining income from the property. Charitable strategies typically work best for donors with philanthropic goals who want to balance income needs with charitable giving. Consult your CPA and estate planning attorney to evaluate whether charitable strategies are appropriate for your situation.
Strategy #7: Hold Until Death (Pass to Next Generation)
When inherited property is held until the heir's death, the property may receive another step-up in basis for the next generation of heirs. Under current tax law, this step-up can potentially eliminate any capital gains that accrued during the first heir's ownership, similar to how the initial step-up eliminated gains during the original owner's lifetime.
Multi-Generational Example
You inherit property at $400,000 basis
Property grows to $600,000 during your lifetime
At your death: Your heirs get $600,000 stepped-up basis
The $200,000 gain during your ownership is never taxed
This strategy works well for property that generates income (such as rental property) and for families who want to build multi-generational wealth. The limitation is obvious: you cannot access the equity during your lifetime without triggering taxes.
State Tax Considerations
While federal tax rules apply nationwide, state taxes vary significantly. Some states have no income tax at all, while others add substantial additional taxes to capital gains.
States with No State Income Tax
For many states—such as Texas, Florida, Nevada, Wyoming, Alaska, Tennessee, South Dakota, and New Hampshire—there is no state income tax on capital gains. If your inherited property is located in one of these states, you will only pay federal capital gains taxes on the sale. This can save 5-13% compared to high-tax states. State tax laws change, so consult your CPA for current rules in your state and to calculate your specific tax liability.
High Capital Gains Tax States
California taxes capital gains as ordinary income at rates up to 13.3%. New York can reach 10.9%, and New Jersey up to 10.75%. If your inherited property is in a high-tax state, tax planning becomes even more important.
For Parents: Planning to Pass Property to Your Children
Important: The strategy discussed below is for educational purposes only. Estate planning involves complex tax and legal considerations that vary by individual circumstances. Consult your CPA and estate planning attorney before making any decisions.
If you are a property owner in your 70s, 80s, or 90s and know your children will eventually inherit your real estate, there is a powerful strategy worth considering that can make inheritance cleaner and easier for your heirs while eliminating your management burden today.
The Problem with Passing Rental Property Directly
Passing rental property directly to children can create complications. Multiple heirs may disagree about whether to sell or hold. Someone has to manage the property or coordinate with property managers. If the property has deferred maintenance or tenant issues, children inherit those problems. And if heirs have different financial situations, one may need to cash out while others want to hold, creating family conflict.
A Better Path: 1031 into DST, Then 721 into REIT
Instead of holding rental property until death, consider this sequence that can benefit both you and your heirs:
The Parent-to-Child Estate Planning Strategy
1031 exchange your rental property into a DST today. This eliminates your landlord responsibilities immediately. No more tenant calls, maintenance headaches, or property management coordination. You can receive potential monthly passive income from professionally managed, institutional-quality real estate.
Select DSTs with 721 exit options. When the DST properties are sold (typically 5-10 years), you have the option to convert your DST interest into REIT Operating Partnership (OP) units through a 721 exchange, continuing to defer capital gains.
Hold REIT shares until death. The REIT shares are simple, liquid securities. When you pass away, your children inherit the shares with a stepped-up cost basis, eliminating all the capital gains that have been deferred since your original property.
Your children receive clean, equal ownership. Unlike dividing a physical property among multiple heirs, REIT shares can be split evenly among any number of children. Each heir can independently decide to hold for income or sell for cash without needing agreement from siblings.
Why 721 Exchange Creates Cleaner Inheritance
Equal Division Among Heirs
REIT shares can be divided precisely among multiple children, unlike a single property that may need to be sold to distribute proceeds fairly.
Independent Decision Making
Each heir can choose to hold or liquidate their shares without requiring consent from siblings or co-owners.
Step-Up in Basis at Death
Your heirs receive the shares at current market value, eliminating decades of deferred capital gains.
No Property Management Required
Children inherit passive REIT ownership, not landlord responsibilities. They receive distributions without any active involvement.
Potential Liquidity for Heirs
Depending on the REIT structure, heirs may have the ability to redeem shares for cash, unlike DST interests or direct property which can take months to sell.
Example: The Johnson Family
Robert, age 78, owns a rental duplex worth $800,000 that he bought for $150,000 in 1990. He has three children and wants to ensure they inherit equally without family conflict.
Instead of holding the property until death (which would require selling and dividing proceeds, or having one child "buy out" the others), Robert executes a 1031 exchange into a DST with a 721 exit option. He eliminates his property management duties immediately and begins receiving monthly distributions.
Five years later, the DST sells and Robert converts to REIT shares. At age 85, he passes away, and his three children each inherit one-third of the REIT shares with a stepped-up basis. Each child can independently decide whether to hold for income or redeem for cash, with no family negotiations required.
This example is for illustration only. Consult your CPA and estate planning attorney for advice specific to your situation.
Important Disclosure: This strategy involves complex tax, estate, and securities law considerations. The 721 exchange is not suitable for all investors and carries specific risks. This information is educational only and does not constitute tax, legal, or investment advice. Consult with your CPA, estate planning attorney, and financial advisor to determine if this approach is appropriate for your specific situation.
Important consideration: The 721 exchange into REIT shares means giving up the ability to do future 1031 exchanges with that capital. This is a one-way decision. For parents who intend to hold until death anyway, this may be acceptable since the goal is estate transfer, not continued tax deferral for personal use.
How Anchor1031 Can Help
Whether you have recently inherited property or you own property that you plan to pass along to your children, Anchor1031 specializes in helping investors execute tax-efficient strategies using 1031 exchanges into Delaware Statutory Trusts (DSTs).
Our team can help you evaluate your options, identify DST investments with 721 exit options for estate planning, and coordinate with your CPA and estate planning attorney to ensure your strategy aligns with your goals.
Do you pay capital gains tax on inherited property?
Generally, heirs do not pay capital gains tax on appreciation that occurred during the original owner's lifetime. Under IRC Section 1014, the step-up in basis provision adjusts the property's tax basis to its fair market value on the date of death. Capital gains tax typically applies only to appreciation occurring after inheritance. For example, if a parent bought a home for $100,000 and it was worth $500,000 at death, the heir's basis becomes $500,000, not $100,000. Consult your CPA to calculate specific tax liability based on individual circumstances.
What is the step-up in basis loophole for inherited property?
The step-up in basis provision adjusts inherited property's tax basis to its current fair market value rather than the original purchase price. For example, if a parent bought a home for $50,000 in 1970 and it is worth $500,000 at death, the heir's basis becomes $500,000, not $50,000. This provision can effectively eliminate $450,000 in taxable gain, potentially saving substantial amounts in capital gains taxes depending on the heir's tax rate. Consult your CPA to understand how this provision applies to specific inheritance situations.
How do I avoid capital gains on my parents' house?
Common strategies that heirs may consider include: (1) selling soon after inheritance to minimize additional appreciation, (2) converting the property to a primary residence and potentially using the Section 121 exclusion after meeting residency requirements, (3) using a 1031 exchange if the property qualifies as investment property, or (4) offsetting gains with capital losses from other investments. The appropriate strategy varies based on individual financial situations and goals. Consult your CPA to evaluate which options may work best for specific circumstances.
Can you do a 1031 exchange on inherited property?
Generally, inherited property may qualify for a 1031 exchange if it meets the requirements for investment or business property. Primary residences typically do not qualify for 1031 exchanges. When inheriting rental property or commercial real estate, heirs may use a 1031 exchange to defer capital gains by reinvesting into another like-kind investment property, including Delaware Statutory Trusts (DSTs). The property must be held for investment intent, which the IRS generally accepts after holding for 12-24 months. Consult your CPA and qualified intermediary to ensure compliance with IRS requirements.
How is inherited property taxed when sold?
When inherited property is sold, capital gains tax generally applies only to appreciation occurring after the original owner's death. The IRS typically treats inherited property as long-term capital gains regardless of the holding period, qualifying for federal rates of 0%, 15%, or 20% depending on the taxpayer's income level. State taxes may also apply depending on the property location and the taxpayer's state of residence. Consult your CPA to calculate specific tax liability based on individual circumstances.
What happens if I inherit property with a mortgage?
An existing mortgage generally does not affect the stepped-up basis calculation, which is based on the property's fair market value. However, heirs typically need to continue making mortgage payments or pay off the loan. When property is sold, the mortgage payoff generally comes from sale proceeds before distribution to heirs. For 1031 exchanges, replacement property must have equal or greater debt to avoid taxable "boot." Consult your CPA and qualified intermediary for guidance on specific situations.
How do I establish the basis for inherited property?
Establishing basis for inherited property generally requires documentation showing the property's fair market value on the date of death. This typically involves obtaining a professional appraisal from a qualified appraiser. Other supporting documentation may include estate tax returns (if filed), comparable sales data, and property tax assessments. These records should be retained for potential IRS verification. Obtaining an appraisal at the time of death is generally important for establishing a defensible basis. Consult your CPA to determine what documentation is appropriate for specific situations.
Is selling an inherited house considered income?
The inheritance itself is generally not taxable income. However, when inherited property is sold, any capital gain (sale price minus stepped-up basis minus selling expenses) is reported as capital gains on the tax return. This is generally considered capital gains income, not ordinary income, and is typically taxed at preferential long-term capital gains rates of 0%, 15%, or 20% depending on the taxpayer's income bracket. Consult your CPA to understand how this applies to specific situations.
How can I pass property to my children without them paying capital gains tax?
One common estate planning strategy is holding the property until death so heirs receive a stepped-up basis. For property owners who want to eliminate management responsibilities while still providing a clean inheritance, some consider a 1031 exchange into a Delaware Statutory Trust (DST) with a 721 exit option. When the DST sells, there may be an option to convert to REIT shares. At death, heirs may inherit the REIT shares with a stepped-up basis, potentially eliminating deferred capital gains. REIT shares can also divide easily among multiple heirs. Consult your CPA and estate planning attorney to determine if this strategy is appropriate for specific situations.
Bottom Line
Inherited property comes with significant tax advantages that most people do not fully understand. The step-up in basis eliminates capital gains from the original owner's lifetime, and strategic planning can minimize or eliminate taxes on any appreciation after inheritance.
For those who inherit rental property, 1031 exchanges into DSTs offer a path to defer taxes indefinitely while transitioning from active landlord to passive investor. Combined with estate planning strategies like the 721 exchange and eventual step-up at death, families can preserve wealth across generations.
The right strategy depends on your goals, timeline, and tax situation. Consult your CPA and estate planning attorney to evaluate your options before making decisions about inherited property.
Disclaimer: This article is for educational purposes only and does not constitute tax, legal, or financial advice. Anchor1031 is not a CPA firm or law firm. All strategies discussed require evaluation by your qualified tax and legal professionals.
About the Author
Trevor Sybertz, Partner
Trevor Sybertz is a Partner at Anchor1031, where he specializes in educating clients about 1031 exchanges, private real estate offerings, and REITs. With over a decade of experience in commercial real estate and capital markets, Mr. Sybertz has helped clients invest more than $100M in equity across a wide range of real estate assets and markets. Previously, he served as a Director at RealtyMogul, and before that as Assistant Vice President of Institutional Equity Sales at Keefe, Bruyette & Woods where he covered commercial mortgage REITs and international equities.
Sources
This article references the following IRS publications and Internal Revenue Code sections:
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.
