So, you’ve just inherited some property. While this is an exciting (perhaps even life-changing) event, your excitement around the inheritance may also be short-lived. Not only do you have to worry about the oncoming emotional and financial complexities of your newly acquired asset, but you must also stay alert to unexpected costs, including capital gains taxes.
While you may wonder if you can avoid paying capital gains tax on inherited property, know that there are no legal ways to do so. However, a Deferred Sales Trust (DST) can provide heirs to property, such as yourself, with a tax-smart, flexible way to manage inherited property.
So that you are better prepared for your property inheritance, here is what you should know regarding the hidden costs around property inheritance and the benefits to using a DST for this type of asset.
The Hidden Costs of Inheriting Property
Stepped-Up Basis Basics
Your cost basis on an asset is the amount you initially paid to purchase an investment, such as property. In the event you inherit it, the property will receive a new basis. This is called a stepped-up basis.
A stepped-up basis is a tax adjustment placed on the inherited property that reflects the fair market value at the time of the original owner’s passing. In other words, the price of the asset is now “stepped-up” to reflect current market value.
For example, let’s say your grandparent purchased their home for $200,000. At the time of their passing, their house is worth $400,000. When you inherit the property, your stepped-up basis becomes $400,000.
Capital Gains Taxes
Unlike inherited cash, you do not owe capital gains taxes when you inherit a property. However, you may find yourself exposed to significant capital gains taxes if you decide to sell your inherited property, an expensive cost you may not be prepared for. This is where the stepped up basis can help, though.
The IRS does not calculate your capital gains based on the original cost basis, but rather on the stepped up cost basis. Thus, if you sell your grandparents house for $500,000, you would only owe capital gains on $100,000 since the stepped up basis is $400,000.
Be sure to keep all documentation about the value of your inherited property, as you may also find it difficult to prove the value of your inherited property if you do not have documentation available.
Property Maintenance and Carrying Costs
Even if a property is paid for in full, and you don’t have a mortgage payment, owning it is never free. You still need to plan for ongoing expenses like insurance and property taxes. And when the plumbing leaks or the HVAC stops working, those are home maintenance items that will come out of your pocket. It’s the financial burden of holding non-liquid assets.
Probate and Estate Settlement Costs
The goal of probate is to verify a deceased person’s will is executed accurately. However, this court-supervised process can significantly delay your access to your inherited property. You may even have to pay legal, settlement, or probate fees during this process.
Deferred Sales Trust for Inherited Property
Now that we’ve addressed some hidden costs associated with property inheritance, how does a Deferred Sales Trust fit into the picture?
A DST defers capital gains taxes by helping individuals sell highly appreciated assets, such as property, through a trust. Here’s how this process works for property heirs:
Step 1: A Deferred Sales Trust trustee assists the heir in setting up a DST.
Step 2: The heir transfers the inherited property to a DST before selling.
Step 3: The trust then sells the property and holds the proceeds, distributing installments over time and investing proceeds in accordance with the DST.
By using a DST, you can defer large capital gains tax bills when you sell inherited property. In other words, you can spread tax liability over an extended period of time, years even, thereby keeping more capital working for future heirs.
You also retain the ability to guide how the reinvestment of the proceeds, growing their inherited wealth. A DST allows you to reinvest proceeds into stocks, bonds, real estate, or other assets. Investment diversification also provides greater risk management as you are no longer limited to a single inherited property. You can use DST payouts for intergenerational wealth planning.
When to Use a DST
You may find a DST to be a valuable addition to your tax strategy if your new asset fits any of the following scenarios:
- Inherited Rental Properties: If you inherited rental properties, a DST allows you to avoid ongoing maintenance hassles and cash out efficiently.
- Inherited Commercial Real Estate: With inherited commercial real estate, a DST makes it possible for you to maximize the proceeds from these valuable but costly-to-maintain properties.
- Inherited Family Homes: If you find yourself the inheritor to a family home, a DST can help you manage emotional ties to this asset while you plan next steps.
- Multiple Heirs with Different Financial Goals: Have you inherited the same property as someone else? A DST makes it easier to convert non-liquid assets, such as property, into diversified investments through the trust. This may help you solve potential conflicts with other heirs.
Conclusion
A Deferred Sales Trust is an excellent financial tool as it can greatly reduce the costs you may face with inherited property. Whether you decide to sell right away or hold onto the property while it appreciates, a DST could be your ticket to making the most of your inheritance. Your financial strategy should lead you to achieving your goals and dreams. If that doesn’t involve owning the family farm, it may be time to contact a DST attorney to discuss how to structure your DST, sell the property, and defer capital gains payments.