When you inherit from someone other than your spouse, you generally receive a step-up in basis. The basis to you, the beneficiary, is stepped-up from the basis of the original owner to the current market value at the date of death. You now have several choices on what to do with this inherited home. Based on the real estate market, your needs, and your financial situation, you may, sell, move in, or turn the house into a rental property.
If you sell the house, you pay taxes only on gains over the stepped-upbasis. Currently, the long-term capital gains tax rate can run upwards of 20%, depending on your tax bracket.
If you decide to move into the house, your basis starts with the stepped-up basis, and you may qualify for the exclusion of gain when you sell.
Turning your inherited home into a rental could provide a big tax benefit, too. The depreciation expense will serve to reduce your taxable rental income. For tax purposes, the house (not the land) is considered a depreciable asset, and a certain percentage of its value can be deducted annually. You can also depreciate improvements, such as a new roof, provided they add value or will extend the property's life. The only catch is that you will have to pay back that depreciation to the Internal Revenue Service when you sell. That means you' will owe more in capital gains, if there are any. You also won't qualify for the exclusion since the house isn't your principal residence.
If you inherit the house from your spouse, you retain the original basis. It is important to remember that you may be eligible for up to the $500,000 exclusion of gain if you sell within two years of the date of death of your spouse.