Inherited Property Tax Rules: Stepped-Up Basis, Filings, and Penalties

If you’ve inherited a house or other real estate, the tax picture has four moving parts: federal estate tax (which most estates don’t owe), any state inheritance or estate tax, your income tax on rent the property earns, and the capital gains you’ll owe when you sell. Inherited property tax rules also give heirs one significant advantage — a reset of the property’s cost basis to its value on the date of death — that can eliminate most or all of the capital gains tax if you sell soon after inheriting.

Here is what applies to you as an heir, what your executor handles before the property reaches you, and the deadlines that carry real penalties.

Federal Estate Tax Rarely Reaches Heirs

The federal government taxes the transfer of wealth at death based on the gross estate, which includes the fair market value of all assets the deceased person owned, including real estate, on the date of death.¹ For deaths in 2026, the basic exclusion amount is $15 million per individual, set by the One, Big, Beautiful Bill Act signed in July 2025.² Married couples can effectively shield up to $30 million.

Only the portion above the exemption is taxed. Rates start at 18 percent and reach a maximum of 40 percent.³ The executor pays this tax from estate assets before any property passes to heirs. You do not write a personal check for federal estate tax.

The Stepped-Up Basis Is Your Main Tax Break

Under Internal Revenue Code Section 1014, when you inherit property your cost basis resets to the property’s fair market value on the date the owner died.⁴ Basis is the number the IRS uses to calculate your taxable gain when you sell.

Say your parent bought a house for $120,000 in 1990, and it’s worth $520,000 on the date of death. Your basis is $520,000, not $120,000. If you sell for $525,000, you owe capital gains tax on $5,000. Without the step-up, you’d owe tax on $405,000. Any gain you do realize on inherited property is treated as long-term capital gain regardless of how briefly you actually held it, so the lower long-term rates apply.

Get a professional appraisal to document the date-of-death value. This is what backs up your basis if the IRS ever questions it. Fees generally run from about $200 to $1,300 depending on property and location. The document is worth far more than the fee.

Community Property Gets a Double Step-Up

In community property states, when one spouse dies the entire property — including the surviving spouse’s half — receives a stepped-up basis to the date-of-death fair market value.⁴ In common-law states, only the deceased spouse’s share gets the step-up. The IRS confirms this treatment, noting that the total fair market value of the community property generally becomes the basis of the entire property.⁵

The double step-up applies in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. For a couple whose home appreciated $300,000 during the marriage, the difference can save tens of thousands in capital gains tax.

Selling or Moving Into the Inherited Home

Because the basis already reset at death, selling the property soon after typically produces little or no gain. If you make the inherited house your primary residence, you may eventually qualify for the Section 121 exclusion — up to $250,000 of gain ($500,000 for married couples filing jointly) shielded from tax.⁶ You must own and use the property as your main home for at least two of the five years before the sale. Combined with the step-up, this often erases capital gains tax entirely on an inherited home.

A surviving spouse gets extra help. The statute lets an unmarried surviving spouse count the deceased spouse’s period of ownership and use toward the two-year requirement.⁶ If the surviving spouse sells within two years of the death and both spouses previously met the use test, the exclusion is the full $500,000 married-couple amount.

State Inheritance and Estate Taxes

Some states impose their own transfer taxes that operate independently of the federal system. Two kinds exist. A state estate tax is calculated on the total value of the deceased person’s holdings and typically kicks in at a much lower threshold than the federal exemption. A state inheritance tax is levied on the person receiving the property.

Five states currently impose an inheritance tax: Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Iowa eliminated its inheritance tax as of 2025. In all five, the rate depends on the heir’s relationship to the deceased. Spouses are universally exempt, and children typically pay nothing or very little. Distant relatives and unrelated beneficiaries face the highest rates, topping out at 16 percent in Kentucky and New Jersey. Several states also impose separate estate taxes, and Maryland imposes both.

These taxes generally apply based on where the deceased lived or where the property sits, not where the heir lives. If you inherit real estate in an inheritance-tax state but live elsewhere, you still owe that state’s tax.

Rental Income During Probate and After

If the property earns rent while the estate is being settled, that income belongs to the estate, which is a separate taxpayer. The executor must file Form 1041 if the estate earns $600 or more in gross income during the tax year.⁷ Rental income is reported on Schedule E and flows to Line 5 of Form 1041.

The estate can deduct expenses necessarily incurred in preserving the property during administration, including storage and routine maintenance. Additions and improvements are not deductible, and deductions are limited to the period the executor reasonably needs to retain the property.⁸ Brokerage fees on a sale are deductible when the sale is necessary to pay debts, taxes, or distribute the estate.

Once the property transfers to you and you continue renting it, the income moves to your personal return. Your depreciable basis is the stepped-up fair market value minus land value, and you start a fresh depreciation schedule of 27.5 years for residential rental property using the straight-line method. Capital improvements made after you inherit are depreciated separately.

Local Property Tax Reassessment

Inheriting a house often triggers a local property tax reassessment. If the property hasn’t been reassessed in years, the new valuation can substantially increase the annual bill.

Some jurisdictions offer protections for transfers between parents and children or other direct family members, allowing heirs to keep the previous assessed value under certain conditions. These exclusions vary widely and often cap how much value can be preserved. The details depend entirely on where the property sits.

Most local assessors require a change-of-ownership report after a death, typically within a set number of days. Failing to file that notice doesn’t prevent reassessment; the assessor discovers the transfer later and may impose penalties or back-assess retroactively. Property held in a trust is not exempt from this — the beneficial interest still transfers at death and triggers the same reporting obligation.

Key Filings and Deadlines

The federal estate tax return, Form 706, is due nine months after the date of death.⁹ The executor can get an automatic six-month extension by filing Form 4768 before the original due date. No explanation is required.¹⁰ The extension covers filing, not payment; interest and penalties can accrue on unpaid tax during the extension.

Once the IRS processes the return, the executor can request an estate tax closing letter by verifying that transaction code 421 appears on the account transcript, then submitting the request through Pay.gov.¹¹ This letter confirms the IRS has accepted the return and is often required to finalize probate.

Form 1041 for estate income follows a different calendar. The estate’s first tax year begins on the date of death, and the return is due by the 15th day of the fourth month after the tax year ends.⁷

Portability for Surviving Spouses

When a married person dies without using their full $15 million exemption, the surviving spouse can claim the leftover amount — the Deceased Spousal Unused Exclusion. The executor must file Form 706 to make the election, even if no estate tax is owed. The standard deadline is nine months after death, with a six-month extension available on Form 4768.⁹

Executors who miss that deadline have a safety net. Under Revenue Procedure 2022-32, estates not otherwise required to file Form 706 can make a late portability election up to five years after death. The executor writes “Filed Pursuant to Rev. Proc. 2022-32 to Elect Portability under section 2010(c)(5)(A)” at the top of the return.⁹ Once made, the election is irrevocable.

Form 8971 Basis Consistency

If the estate is required to file Form 706, the executor must also file Form 8971 and give each beneficiary a Schedule A identifying the value of the property received.¹² This creates a binding ceiling: a beneficiary cannot claim a basis higher than the value on Schedule A. The filing deadline is 30 days after Form 706 is due or 30 days after it is actually filed, whichever comes first.

Not every estate triggers this. If the gross estate plus adjusted taxable gifts falls below the basic exclusion amount, Form 8971 is not required, and it’s also not required when Form 706 is filed solely to elect portability.¹² When it does apply, the executor must file supplements if property transfers later or if values change.

Penalties for Late Filing and Valuation Errors

Missing the Form 706 deadline without an extension triggers a failure-to-file penalty of 5 percent of the unpaid tax for each month the return is late, up to 25 percent. A separate failure-to-pay penalty of 0.5 percent per month runs concurrently, also capped at 25 percent. When both apply in the same month, the filing penalty is reduced by the payment penalty amount. Interest compounds on top; the IRS underpayment rate for the second quarter of 2026 is 6 percent.¹³

Valuation errors carry their own penalty. If a value reported on the estate tax return is 65 percent or less of the correct value, the IRS imposes a 20 percent accuracy-related penalty on the resulting underpayment. That penalty doubles to 40 percent for a gross valuation misstatement, where the reported value is 40 percent or less of the correct amount. The penalty is triggered when the underpayment attributable to the valuation error exceeds $5,000.¹⁴ Lowballing a property’s value to reduce estate tax can backfire badly if the IRS disagrees, which is why a credible appraisal matters at every stage.

1
Office of the Law Revision Counsel. 26 USC 2031
2
Internal Revenue Service. What’s New – Estate and Gift Tax
3
Office of the Law Revision Counsel. 26 USC 2001
4
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
5
Internal Revenue Service. Publication 555, Community Property
6
Office of the Law Revision Counsel. 26 US Code 121 – Exclusion of Gain From Sale of Principal Residence
7
Internal Revenue Service. Instructions for Form 1041 and Schedules A, B, G, J, and K-1
8
eCFR. 26 CFR 20.2053-3 – Deduction for Expenses of Administering Estate
9
Internal Revenue Service. Instructions for Form 706
10
Internal Revenue Service. Instructions for Form 4768
11
Internal Revenue Service. Frequently Asked Questions on the Estate Tax Closing Letter
12
Internal Revenue Service. Instructions for Form 8971 and Schedule A
13
Internal Revenue Service. Information About Your Notice, Penalty and Interest
14
Office of the Law Revision Counsel. 26 US Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments