Editor’s note: Rich Arzaga is a longtime columnist with Rethinking65. Read more of his articles here.
Rich Arzaga
Inheriting real estate from parents can be a significant financial lift for beneficiaries. But 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. Determine if This Will 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. Case-Shiller research 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 “lifestyle asset” 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.
A Matter of Priorities
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). The step-up in basis 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 and it’s 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 for beneficiaries 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 Value and Possibly the Condition of the Property
Getting an appraisal of value or comparable market analysis (CMA) is an important step regardless of whether the estate may or may not retain the property. However, there are two trains of thought on whether or not to assess the condition of the property:
1. If the Estate is Leaning Toward Keeping the Property Among the Beneficiaries
In this case, ordering reports to help determine the property’s condition is appropriate. If the estate is not planning to retain the property among the beneficiaries, ordering property inspections and reports is still an option. However, many real estate professionals would advise against this for the second point below. If ordering the reports is the option the estate is exploring, the executor will want to check with the estate planning attorney to determine if these reports require disclosures to the buyer if the property is ultimately listed for sale. Detrimental reports will reduce the sales price of the property. The state regulates real estate law so that state disclosure laws will differ, requiring the need for a local attorney.
2. If the Property is Headed for Sale
Ordering inspections to learn more about the property’s condition may not be a good idea. In this case, selling the property in an estate sale “as is” is acceptable. 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 No. 1 reason for litigation following the closing of escrow. It may not be prudent to put the estate in the position of explaining or defending reports and property issues.
To the merits of deliberately knowing as little as possible under these conditions: This article is written from the perspective of advising the executor, the beneficiaries and the estate. Reducing risk during this process is prudent. If a buyer decides to risk purchasing a property “as is,” they will get the combined risk-reward that comes with that type of purchase. Advising clients on purchasing a property “as is” is not a recommendation I would make. However, if the buyer is an experienced flipper who has seen success and failure with this method, I could understand the purchase.
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 ig it 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, they should seriously consider hiring 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 critical. In fact, helping beneficiaries evaluate rental real estate is central to what we do.
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 when 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. If multiple heirs are involved, a legal advisor can help navigate potential disputes or complications with property ownership.
7. Plan for Future Estate Transfers
Beneficiaries who plan to keep the property should consider estate planning to ensure a smooth transfer to their future heirs. Creating a trust or using 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 the tax implications, evaluating their options carefully, and seeking professional advice.
Rich Arzaga, CFP®, CCIM, founder and CEO of The Real Estate Whisperer™ Financial Planning, is a flat-fee financial advisor who provides advice only and does not manage investments. This enables him to give undivided attention to his clients’ needs. Rich advises 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. He is also an adjunct professor for the UC Berkeley Personal Financial Planning programs. Find him here on LinkedIn.
