How to Avoid Paying Capital Gains Selling a Gifted House

If you take title to a house as a gift or inheritance, you may have to pay capital gains tax when you sell it. There are several options for avoiding the tax.

The IRS says almost anything you own that isn't cash is a capital asset. When you sell an asset such as a house, your gain on the sale is capital gains income, usually taxed at a lower rate than your paycheck. Your gain is the sale price less the basis of your house — usually the purchase price adjusted by factors such as depreciation or improvements.

Example: You buy a house for $200,000. You spend $10,000 upgrading the kitchen and $20,000 on a new deck. You sell for $300,000. Your basis is $230,000, so your capital gain is $70,000.

When you inherit a house or someone gives it to you, you have no purchase price, so the rules change:

• Inherited real estate: Your basis is usually the fair market value of the property on the day the previous owner died.
  
• Gift: Your basis is the donor's adjusted basis immediately before she transferred title to you.
  

The exception is if you sell at a loss and the fair market value is less than the adjusted basis. In that situation, you figure the loss based on the value rather than the donor's basis.

Moving into the house is one way to avoid capital gains. Tax law exempts $250,000 on the sale of your personal home, or $500,000 if you're married and file jointly. You must own the house for two of the five years before you sell and live in it for two of the five years.

Under Section 1031 of the tax code, there's no capital gains on the sale of a rental or investment property if you exchange it for a comparable property within six months.

Example: Your father gifts you a rental property. You sell it and buy another rental of equal value, avoiding capital gains tax until you sell the second house.

The 1031 rules are complicated — just buying a replacement house won't cut it; it must be a business or investment property — so you may need professional help.

If you sell an inherited house right after you take title, the sale price will probably be close to your basis. In that case, you'll have little or no capital gains to report. With a gift house, where you assume the donor's adjusted basis, this only works if the fair market value is close to the basis.

If you have more than one capital gains transaction in the same year, you can subtract any losses from the gains. For example, if you sell your gift house for a $20,000 gain but sell another house at a $25,000 loss, you can wipe out your taxable gain.