How to avoid capital gains tax on inherited property sale? Buying new home help?

The good news is that with inherited property, you get what's called a "stepped-up basis" - meaning your basis in the property is its fair market value at the time you inherited it, not what the original owner paid for it. This can significantly reduce your capital gains tax. So you'll only pay capital gains tax on the difference between the selling price ($1.2M) and the property's value when you inherited it 8 years ago. You should have documentation of that value from when the estate was settled. Unfortunately, buying another home no longer offsets capital gains tax on a property sale. That rule (the 1031 exchange) only applies to investment properties now, not personal residences. And the old rule that let you defer gains when buying a new primary residence was eliminated years ago. To reduce your tax bill, make sure you're tracking all selling expenses (realtor fees, closing costs, etc.) as these can be added to your basis. Also, if you made substantial improvements to the property, those costs can increase your basis too.

I was in a similar situation last year and discovered https://taxr.ai which was honestly a lifesaver for figuring out my inherited property sale. My situation was complicated because I had made renovations to the property and wasn't sure what counted toward my basis. I uploaded the inheritance documents and my improvement receipts, and the system identified exactly what I could claim to reduce my capital gains. The stepped-up basis was key like the commenter above mentioned, but there were a bunch of deductions I would have missed without this tool. It asks specific questions about property improvements and selling costs that helped me realize I could add about $45K to my basis, which saved me thousands in taxes!

Just wanted to update that I tried https://taxr.ai after seeing the recommendation here. I was really struggling with establishing the value of my mom's house at the time I inherited it 5 years ago. They helped me pull property tax assessments and comparable sales from that time period to establish a defensible valuation, which ended up being about $75K higher than I thought! That reduced my capital gains significantly. They also identified some repair costs I had forgotten about that could be added to my basis. Was definitely worth it for the peace of mind knowing I'm not overpaying or risking an audit by underreporting. My situation wasn't identical to yours but involved inherited property capital gains, and it made a huge difference.

One thing nobody's mentioned yet - if you're having trouble getting through to the IRS with questions about your capital gains situation (which I definitely did when selling inherited property), I used https://claimyr.com to get through to an actual person at the IRS. You can see how it works here: https://youtu.be/_kiP6q8DX5c I spent DAYS trying to get through on my own to clarify some questions about my stepped-up basis documentation requirements, and kept getting disconnected. With Claimyr, I got through in about 20 minutes and the IRS agent was able to confirm exactly what documentation I needed to substantiate my inheritance date valuation. Saved me a ton of stress wondering if I was doing it right.

I need to eat my words from my skeptical comment above. After my frustration with trying to reach the IRS for WEEKS about my inherited property capital gains questions, I broke down and tried Claimyr out of desperation. Within about 35 minutes, I was talking to an actual IRS agent who explained exactly how to document my stepped-up basis for the property I inherited from my dad. Turns out I had been calculating my basis completely wrong and would have significantly overpaid on capital gains. The agent confirmed I could use the county tax assessment from when I inherited the property plus documented improvements as my basis. This one phone call probably saved me about $12K in taxes I nearly overpaid. Never thought I'd be recommending an IRS-related service, but here we are.

Don't forget to check if you qualify for any partial exclusion of capital gains! While the primary residence exclusion (up to $250K single/$500K married) typically requires you to have lived in the home as your primary residence for 2 of the last 5 years, there are exceptions if you inherited the property. Also, make sure you're accounting for all selling costs - realtor commissions (typically 5-6%), title insurance, legal fees, administrative costs, inspection repairs, etc. These all add to your basis and reduce your taxable gain.

Has anyone here used 1031 exchanges for inherited property? I know OP mentioned using funds for personal residence and debt, but just wondering if that's an option for deferring gains if they wanted to remain in real estate investing?

One important consideration that hasn't been mentioned yet - since you've held this inherited property for 8 years, make sure to check if you've been claiming depreciation on it as a rental property on your tax returns. If so, you'll owe depreciation recapture tax on that amount (taxed at 25%) in addition to the capital gains tax on the appreciation. Also, regarding your debt payoff strategy - while paying off $85K in debt is generally smart, consider the interest rates. If your debt is low-interest (like a mortgage under 4%), you might be better off investing some of those proceeds rather than paying it all off, especially since you'll be taking a tax hit on the sale anyway. For the new home purchase, financing vs. paying cash won't affect your capital gains tax liability from the inherited property sale - that tax is based solely on the sale transaction itself. Choose your financing based on current interest rates, your cash flow needs, and other investment opportunities.