Capital Gains Tax on Inherited Rental Property

The step-up in basis

When you inherit property, your tax basis is generally the property's fair market value on the date of the decedent's death (or an alternate valuation date elected by the estate). This step-up applies regardless of what the decedent originally paid. If the decedent paid $200,000 forty years ago and the property is worth $800,000 at death, your basis is $800,000 — not $200,000. You start fresh at current market value.

What happens to deferred depreciation recapture

All depreciation the decedent claimed during their lifetime — which would have created a large recapture obligation had they sold — is permanently eliminated by the step-up. You, as the heir, have no recapture liability from the decedent's ownership. If you sell immediately at the stepped-up value, you owe no capital gains and no recapture. This is the mechanism behind the 'swap till you drop' estate planning strategy used by sophisticated real estate investors.

Your holding period and depreciation going forward

Inherited property is automatically treated as long-term property regardless of how quickly you sell after inheriting. You are not required to hold for more than one year to access long-term capital gains rates. If you continue to rent the property, your stepped-up basis becomes your new starting point for depreciation — divide the building's fair market value at inheritance by 27.5 years to compute your new annual deduction.

A worked example of the step-up

Your parent bought a rental in 1990 for $150,000 and claimed $120,000 of depreciation over 30 years, leaving an adjusted basis of roughly $30,000. Had they sold for $500,000, they would have faced about $120,000 of unrecaptured Section 1250 gain (up to 25%) and $350,000 of long-term capital gain — a six-figure tax bill. You inherit it instead, at a date-of-death fair market value of $500,000. Your basis steps up to $500,000, and the entire $120,000 of recapture and the built-in appreciation vanish. Sell it the next month for $500,000 and you owe essentially nothing; sell for $520,000 after some appreciation and you owe long-term capital-gains tax on just the $20,000 of post-inheritance gain.

Community property doubles the step-up for spouses

How much steps up depends on how the property was owned. For a rental held as tenants in common or joint tenants, only the decedent's share (typically half) steps up when one owner dies; the survivor keeps their old basis in their half. But in the nine community property states (and for assets in a community property trust), a special rule steps up both halves to fair market value when the first spouse dies — a 'double step-up' that can wipe out decades of appreciation and depreciation for the surviving spouse. This is one of the most valuable and least-known benefits of community property ownership; couples in those states should confirm title is held as community property, ideally with survivorship.

The alternate valuation date

Basis is normally the fair market value on the date of death, but the estate's executor may instead elect the alternate valuation date — the value six months after death — on Form 706. The election is only available if it lowers both the gross estate and the estate tax, and it applies to all estate assets, not just the rental. For an heir, the alternate date sets your basis, so a falling market can produce a lower step-up (and a lower future basis for depreciation and sale). You generally cannot cherry-pick; it is the executor's estate-level decision. Coordinate with the estate's advisor so your basis is documented correctly.

Get a qualified appraisal to lock in basis

Because your entire tax future on the property rests on the date-of-death value, document it with a qualified appraisal, not a rough guess. A defensible appraisal (or, for a modest estate, well-supported comparable sales) establishes the number you will use for depreciation and for gain when you sell — potentially decades later. Undervaluing the property to reduce estate tax can backfire on the heir by lowering the step-up and increasing future income tax; overvaluing invites IRS challenge. In an estate large enough to file Form 706, the value reported there generally binds the heir under the consistent-basis rules, so get the valuation right at the outset.

Sell now or keep renting? Weigh the trade-offs

The step-up creates a clean decision point. Selling soon after inheriting realizes little or no taxable gain and converts the property to cash with essentially no income-tax friction — attractive if you do not want to be a landlord. Keeping it as a rental lets you depreciate the full stepped-up building value (a fresh, larger deduction than the decedent had), and you can later 1031-exchange or hold until your own death for another step-up. The tax cost of continuing to hold is that appreciation and depreciation recapture begin accruing again from the new, higher basis. There is no single right answer — it turns on whether you want liquidity, income, or to continue building a real estate estate.

Watch for estate tax, IRD, and state rules

A few items sit outside the income-tax step-up. The property's date-of-death value is included in the decedent's gross estate, which matters only for very large estates above the federal exemption (in the millions per person) or in states with their own estate or inheritance tax at lower thresholds. Note that the step-up covers the property itself but not 'income in respect of a decedent' (IRD) — for example, rent earned before death but collected after, which retains its ordinary character. And a handful of states impose an inheritance tax on the beneficiary. For most heirs the federal income-tax step-up is the dominant benefit, but confirm state estate/inheritance exposure with the estate's advisor.

When only part of the property is inherited

Not every inheritance is a full step-up. If you already owned a share of the property with the decedent — as co-investors holding it as tenants in common — only the decedent's fractional interest steps up to date-of-death value; your original share keeps its old (often much lower) basis, including its share of accumulated depreciation and recapture. The result is a blended basis: part stepped-up, part carried over. The same split arises when a property is gifted before death (carryover basis on the gifted portion) but a retained interest is inherited. Sorting out which slice got a step-up and which did not is essential to computing depreciation going forward and gain at a later sale, and it is a common place errors creep in — document each interest's basis separately.

Inheriting property held in an LLC, partnership, or trust

How the property was titled changes the step-up mechanics. If the decedent owned the rental directly or through a single-member LLC (disregarded for tax), you generally get a clean step-up in the underlying real estate. If it was held in a partnership or multi-member LLC, what you inherit is a partnership interest that steps up — but the inside basis of the real estate itself only adjusts if the partnership has a Section 754 election in place (or makes one), which lets it 'push down' the step-up to the property and restore your depreciation. Without a 754 election, you can own a stepped-up interest yet still be allocated depreciation based on the partnership's old, low inside basis. Property in a revocable living trust is treated as the decedent's own and steps up normally; an irrevocable trust may or may not, depending on whether the assets are included in the estate. Have the entity's return and operating documents reviewed so the step-up actually reaches the depreciation.

Reporting the sale of inherited rental property

When you sell, report it like any investment real-estate sale — gain or loss on Form 8949 and Schedule D, with business-use portions flowing through Form 4797 — but your cost basis is the stepped-up (date-of-death or alternate-valuation) figure, plus any capital improvements you made after inheriting, plus selling costs. Because inherited property is automatically long-term, any gain gets long-term treatment even if you sell within a year. If you rented it out after inheriting, remember that your post-inheritance depreciation is recaptured on sale (the step-up wiped out the decedent's depreciation, not yours). Keep the appraisal, the estate documents establishing your basis, and your own improvement and depreciation records together — that package supports every number on the sale.

Frequently asked questions

Do I owe depreciation recapture when I sell an inherited rental?

No — the step-up in basis at the decedent's death permanently eliminates accumulated recapture. You start with a clean basis at the date-of-death market value.

Can I depreciate an inherited rental property?

Yes. Your depreciable basis is the date-of-death fair market value of the building (not land). Divide by 27.5 years to get your new annual deduction going forward.

Does a surviving spouse get a full or half step-up?

It depends on the state. In common-law states, only the deceased spouse's share (usually half) steps up. In the nine community property states, a special rule can step up both halves to fair market value — a 'double step-up' — when the first spouse dies.

Do I need an appraisal for inherited rental property?

Strongly recommended. A qualified date-of-death appraisal documents the stepped-up basis you will use for depreciation and for gain when you eventually sell, potentially decades later. For estates filing Form 706, the reported value generally binds the heir under the consistent-basis rules.

Should I sell an inherited rental right away or keep it?

Selling soon realizes little or no taxable gain thanks to the step-up and converts it to cash. Keeping it lets you depreciate the full stepped-up value and defer or step up again later. The choice depends on whether you want liquidity, rental income, or to keep building a real estate estate.

Sources

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.