Inheriting and Selling Real Property in Arizona

For many people, real property assets are a major part of their estate, both during their lives and at the time of their death. A recent Wall Street Journal article, “Selling Inherited Property: What You Need to Know,” emphasizes the importance of:

• how a decedent’s real estate will be transferred to their intended beneficiaries, and
• what the beneficiaries do with the property after they receive it. 

As the Journal article notes, “If you decide to sell [inherited] property, there are legal, financial and emotional factors to take into consideration,” not to mention complications arising from inheritance shared with siblings or other family members.

HOW PROPERTY IS TRANSFERRED AT DEATH

How the real property will be transferred depends largely on the owner’s planning. In Arizona and most states, options for the owner include:

• executing a beneficiary deed, which is used to transfer property upon the death of the owner;
• making a provision in their will, which generally subjects the transfer to the probate process;
• placing the property in a trust, which avoids probate and allows for a smooth transfer in accordance with the trustor’s instructions; or
• co-owning the property with the intended beneficiary in joint tenancy – a simple but risky option that we do not recommend (see our article, “The Perils of Joint Tenancy with Your Adult Children”).

TAX CONSIDERATIONS

Step-up in basis. If you inherit real property and choose to sell it, the sale will likely trigger taxation on the increased value. However, inherited real estate (along with many other types of assets) receives a “step-up in basis,” meaning that any gain stemming from the sale is taxed, at long-term gain rates, on the difference between (a) the property’s selling price and (b) its value at the time of the owner’s death (i.e., not the owner’s purchase amount). Except in rare instances, any appreciation that occurred before the owner passed away is not taxed.

Example: Mr. Smith bought his residence for $500,000. When he died, his home’s value had increased to $750,000. He left the property to his son, who sold it for $800,000. The amount of the sale proceeds that were subject to capital gains taxation was just $50,000 ($800,000 minus $750,000).

To establish the property’s fair market value for the purposes of the step-up in basis, it’s a very good idea to obtain an appraisal as of the date of the owner’s death.

Sale of primary residence. You can achieve additional tax savings if you live in an inherited residence before you sell it. To exclude up to $250,000 of capital gains from the sale ($500,000 if married filing jointly), you must have:

• owned the home for at least two of the five years immediately preceding the sale; and
• lived in the home for at least two of the same five-year period.

Deferring capital gains tax. The Journal article notes that “if you use the inherited property for business or investment before selling it, you might be able to defer paying capital gains through a 1031 exchange.”

A 1031 exchange is a tax-deferred strategy that allows you to sell a business or investment property and reinvest the proceeds into a similar ("like-kind") property to defer (i.e., not avoid) paying capital gains and certain other taxes.

COMPLICATIONS

Things can get difficult when, for example, the owner has multiple children.

Ideally, the owner’s estate planning documents or beneficiary deed will provide for one piece of property to go to one designated person, which keeps things simple and lessens any conflicts among heirs or beneficiaries.

Far less ideally, we have seen situations in which the owner left one or more assets to multiple children, imposing on their fiduciary (i.e., personal representative or trustee) the challenging task of ensuring equitable treatment of all.

To achieve that objective, the fiduciary generally must choose one of these options:

• sell the property and distribute the proceeds equally among the children;
• sell the property to one of the children and distribute the proceeds among all of them; or
• convey the property to one of the children and, to balance things out, distribute other estate assets (cash, securities, personal property, business interests, etc.) to their siblings.

The first option is usually the least troublesome, while the two others can be divisive and lead to estate controversies that increase the cost of estate administration and can reduce the ultimate value of the assets conveyed to the beneficiaries.

To ensure that, after your death, your wishes are honored and the distribution of your assets is achieved efficiently and with minimum stress on your fiduciary and beneficiaries, schedule an estate planning consultation with Ryan Scharber.