Inheriting real estate from parents can be a significant financial lift for beneficiaries.
Receiving this gift comes with significant responsibilities and decisions. Understanding the best practices during this process can help beneficiaries maximize the benefits while avoiding potential pitfalls. Here are some key considerations when inheriting real estate, from understanding tax implications to deciding whether to sell, rent, or keep the property.
1. Will this be a “lifestyle” or “financial” asset
I use the term “lifestyle asset” for items of value that are enjoyed and consumed. Think about a fancy car, jet skis, or vacation property. Those are assets that, while functional, depreciate and are typically not part of a retirement plan. Suppose you view the residence you own as an exception to this definition. The Case-Shiller research(1) shows an average home appreciation rate of 3.5% since 1890 (yes, 1890, a few years after the dedication of the Statue of Liberty). Meanwhile, inflation during this same period was 2.8%. For some, 3.5% home appreciation is acceptable and would be an exception from this perspective.
Another form of lifestyle asset is inherited real estate held for sentimental reasons. The aunts and uncles from my mom’s side of the family grew up in a two-bedroom, one-bath home in the 1940s and 1950s. Two parents and six kids shared a single full bath. Fast-forward, and one of my uncles, who was a big success, raised his own family and ultimately died living in that same home. He could have lived anywhere, but the house had meaning to him. Kids may have the same sentimental feeling when they inherit Mom and Dad’s house. They may not want to live at that home themselves but still may be reluctant to have it leave the family. I would say not all lifestyle asset decisions are good financial decisions.
On the other hand, a financial or investment asset is intended to grow over time and produce a future resource and value to beneficiaries.
From my perspective as a financial planner, if the lifestyle decision does not prevent clients from achieving their most important priorities (ex., retiring well, mitigating risks along the way), then OK. We can adjust later if needed. However, if there is a conflict in achieving these priorities and the inherited property can help, I would spend more time thinking through this decision with clients.
Understanding its use as a lifestyle or financial asset will help beneficiaries make better long-term decisions.
2. Understand the Step-Up in Basis
One of the most significant tax advantages of inheriting real estate is the "step-up in basis." This means the property’s cost basis is reset to its current fair market value on the parent’s death date or six months after death if the executor elects to use the alternate valuation date. This is important because it can dramatically reduce capital gains taxes if the beneficiaries choose to sell the property later. For example, if the parents purchased a house for $200,000, now worth $800,000, the new cost basis would be $800,000. If a beneficiary sells it for $810,000, they will only owe taxes on the $10,000 gain rather than the $610,000 difference between the original purchase price and the current value. Understanding this step can save beneficiaries significant taxes, especially in high-appreciation real estate markets.
3. Consider Estate Taxes
For most people, federal estate taxes won’t be a concern since the federal estate tax exemption is currently relatively high—over $12 million per individual in 2024. However, it’s essential to check if the state has an estate or inheritance tax, as several states have lower exemption thresholds. For example, Oregon’s estate tax exemption is $1 million. It’s essential to consult with a financial advisor or tax professional to assess if the inheritance could trigger any tax liabilities and to plan accordingly.
4. Assess the Condition and Value of Property
This one is not as simple. There are two trains of thought. Please make sure to read the second:
A. Assessing the property’s current condition and market value is essential before deciding what to do with the inherited real estate. A home inspection can provide insights into necessary repairs, while a comparative market analysis (CMA) can help beneficiaries understand the property’s worth in the current market. Knowing the property’s condition and value will help guide whether it makes more financial sense to keep, rent, or sell the home.
B. Agreement on the CMA. This is generally done during the estate settlement process. But be careful when ordering inspections and asking about the property's condition if the beneficiaries have already decided to liquidate it.
Property disclosure laws vary by state and are meant to compel the seller from pulling the wool over the buyer's eyes by being silent on known issues that could materially impact the home's value. Disclosures are the #1 reason for litigation following the closing of escrow.
From my perspective, selling a property during the estate settlement process “as is” is less risky than having first-hand knowledge of property issues. This is not to avoid helping the buyer; it is all about staying out of the process of taking on additional risk. Society has not gotten kinder over time. There is no need to stick a hand inside a potential hornet's nest.
5. Decide Whether to Keep, Rent, or Sell
After evaluating the financial aspects of the inheritance, beneficiaries will need to decide whether to keep, rent, or sell the property. Considering my thoughts at the top of this article, if the property holds sentimental value, keeping it might be the right choice. However, property maintenance can be expensive, especially in a distant location, or requires significant surveillance and upkeep.
If renting the property, be prepared to handle the responsibilities of being a landlord or hire a property management company. Unless the beneficiary is already a professional property manager, seriously consider a property manager. Renting may provide a steady income stream but comes with risks like vacancies, credit loss, property damage, and dealing with unkind tenants. All this, and still the income may or may not contribute to a financial plan as much as taking the capital and investing elsewhere. Understanding the impact of rental property on a plan is our bread and butter. If a beneficiary is unsure about the process of evaluating a rental property, please get in touch with us. The lesson is likely to be eye-opening.
Finally, selling the property may provide a lump sum of cash, which could be used for other investments, retirement savings, or paying off debts. Thanks to the step-up in basis, selling shortly after inheriting may allow beneficiaries to minimize capital gains taxes.
6. Consult with Professionals
One of the most critical steps in inheriting real estate is consulting with financial advisors, tax experts, and estate attorneys. These professionals can provide guidance on the tax implications, help beneficiaries value the property, and advise on the best course of action based on their financial goals. Additionally, if multiple heirs are involved, a legal advisor can help navigate potential disputes or complications with property ownership.
7. Plan for Future Estate Transfers
If beneficiaries plan to keep the property, consider estate planning to ensure a smooth transfer to their future heir. Creating a trust or other estate planning tools can help minimize taxes and streamline the process for the next generation.
Inheriting real estate from parents can be an emotional and financial decision. Beneficiaries can maximize the inheritance and ensure it aligns with their broader financial goals by understanding tax implications, evaluating the options carefully, and seeking professional advice.
About the author/planner/teacher
As the Founder and CEO of The Real Estate Whisperer™ Financial Planning, Rich Arzaga, CFP®, CCIM, is a flat-fee financial advisor who provides advice only. By focusing solely on delivering client-centered financial advice rather than managing investments, he ensures his undivided attention to his clients' needs.
Drawing on his extensive expertise, Rich provides valuable advice on various real estate topics, including buy-sell-hold strategies, tax-deferred and highly appreciated tax reduction strategies, real estate succession planning, and rental property cash flow analysis.
His exceptional knowledge and real estate strategies have earned him recognition in business and finance publications such as the Wall Street Journal, The New York Times, Newsweek, Kiplinger, and The Journal of Financial Planning. As an esteemed adjunct professor at UC Berkeley Personal Financial Planning programs, Rich has been Honored for his excellence in teaching.
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