If you sell your house and make a profit, you must pay capital gains tax—so does the same rule apply when you inherit a house from a deceased relative? The truth is that inheriting property can be taxing—both emotionally and financially. The amount you must pay when you sell an inherited property can indeed take a toll on your bottom line. But before we discuss the details, let's take a closer look at what capital gains tax actually is.

Capital gains tax

Typically when you sell a home for more than you paid for it, you have to pay capital gains tax. It can range from 0% to 20%, depending on your income. Your capital gain on your home sale is determined by subtracting the purchase price from the home's current value. And you could be eligible for an exclusion of up to $250,000 ($500,000 for a married couple) if you’ve lived in the property for at least two of the previous five years.

How much tax do you have to pay when you sell an inherited home?

However, if you inherit a home and sell it later, you will pay capital gains tax based on the value of the home on the date of the owner's death.

"This is known as the 'stepped-up' basis for paying taxes on an inherited home.

For example, if you inherit your grandmother’s house and it was worth $200,000 when she died, and you sold it later for $210,000, you would subtract the stepped-up basis of the home ($200,000) from the sales price ($210,000) to determine the taxable gain ($10,000). Therefore, you would have to pay tax on the $10,000 gain.

People who inherit property aren't eligible for any capital gains tax exclusions. But if you sell the home for less than the stepped-up basis, you can deduct the loss amount up to $3,000 per year. (Any more than that can be rolled over to next year to be deducted.)

Will home improvements on an inherited home lower your tax bill?

So what happens if you update the kitchen, redo a bath, or make other improvements to the property you inherited before you sell it? The good news is that you can use those improvements to reduce your tax bill and potentially increase your profit.

If you do decide to make some updates, you can subtract that amount from any capital gains taxes you owe when selling the property. So keep track of those receipts!