Inheriting a house or a Picasso is fantastic, unless a tax bill comes with it. If you decide you want to sell your inheritance, profits on the sale are taxable. If you keep the property, you may have other taxes, such as property tax on a house. Some states even charge an inheritance tax. There are ways to minimize the tax bite, though.
When you sell property you bought yourself, the taxable gain is the difference between the basis or purchase price and the sales price. When you inherit, it doesn't matter what the original purchase price was: your basis is the fair market value on the day the former owner died. If you inherit a $200,000 painting, say, and sell it immediately, it won't have time to rise in value. If it sells for $200,000, none of that is taxable income.
The federal government offers a great tax break when you sell your own home. If you've owned the house and lived there for two of the five years before the sale, you can exclude $250,000 of gain on the sale from taxes. On a joint return, you can take $500,000 if you and your spouse both live there. If you inherit a house and don't want to sell until the market picks up, moving in can protect you from tax on any profits when you finally unload it.
Some taxes aren't as easy to duck as capital gains tax. For example, if you inherit a house, you owe property tax on the property for as long as you own it. This is not avoidable, regardless of how you acquire the property. Six states impose inheritance taxes, which hit you if you live there, if the deceased lived there or if you inherit real estate there. Your relationship may protect you -- spouses don't pay inheritance tax, for instance, and certain close relatives typically pay less than other people -- but if you inherit property and the inheritance tax applies, you must pay it.
Disclaiming an Inheritance
One way to avoid tax completely is to never inherit at all. If you do this, you're said to "disclaim" your inheritance. You file a written statement with the estate executor saying you don't want the property and it passes to the next heir in line. Legally, you've never owned it, so there's no tax bill for you. You have nine months after the death to do this.