The hidden tax trap when inheriting property

Too often, families assume that an inherited home is tax-free. Unfortunately, that’s not always the case, and misunderstanding the rules can turn inheritance into an unexpected liability.

The myth of the ‘tax-free’ inheritance

It’s a common belief that once you inherit a property, it’s yours to sell or rent without tax consequences. In reality, this mostly applies only when the inherited property was your parents’ main residence and continues to be used as a main residence.

If you have inherited your parents’ second property, or inherited a property purchased via a trust, you can trigger a capital gains tax (CGT) event, not only when you sell the property, but also when you inherit the property.

If you directly inherited from your parents’ estate, and the property was originally purchased before 20 September 1985, your inherited cost base for CGT purposes becomes the market value of the asset on the day your parent died. This rule gives you 40 plus years of tax-free capital gains should you eventually sell the asset and trigger CGT. However, if your parents acquired a second property on or after 20 September 1985, your inherited cost base for CGT purposes is what your parents bought the property for. Should you later sell the property and trigger CGT, you are responsible for the tax on the gains made whilst your parents owned the property.

Should you inherit a property that was purchased inside a trust, CGT Event E7 could apply. CGT event E7 happens if a trust transfers a CGT asset to a beneficiary to make good a beneficiary's interest in the trust capital. The time of the CGT event is when the disposal occurs. This capital gain from the deemed disposal is generated within the trust but is assessed in the beneficiaries’ hands. This means you can be liable for CGT when you inherit a property, rather than when you sell it. The consequences of this CGT event present cash flow issues as it creates a tax liability, without liquidating the asset to generate the cash flow.

CGT and the 2-year rule

Here’s where timing becomes everything. Under tax law, if the inherited property was the deceased’s main residence and is sold within two years of their death, the sale can be CGT-free.

But if that two-year window closes – whether because of family indecision, delays in probate, or market timing – the exemption can be lost, and a large portion of your windfall may go to the tax office instead.

A short delay or a well-intentioned rental arrangement can quickly transform what looked like a tax-free inheritance into a taxable gain.

Safe zone v danger zone

Think of the rules in three zones:

· Safe zone: The property was the deceased’s main residence, and you sell and settle within two years. The sale is CGT-free. For example, should you choose to turn the house into an investment property and rent it whilst the estate is being administered, it will keep the tax-free status if the two-year condition is met.

· Danger zone: The property was rented or used as an investment after inheritance. Should the two-year exemption period be lost, then the cost base of the former main residence becomes the market value at date of death, and the property becomes a CGT asset. The ATO will want its share of any capital gain upon the sale of the property.

· Grey area: The property isn’t sold within two years of inheriting, and the property remains vacant. The two-year exemption expires, and if the Australian Taxation Office does not grant an extension, the cost base of the former main residence becomes the market value at date of death, and the property becomes a CGT asset. Even a modest increase in property value can trigger a large tax bill.

Valuations and the cost base

One of the most overlooked steps when inheriting a property is getting a professional valuation at the date of death.

That valuation determines the property’s cost base, the figure used to calculate future gains or losses. Without it, there is a higher chance the ATO will review the calculations, and you may be liable for penalties if this is not done correctly.

For properties acquired before 20 September 1985 (the start of CGT), the market value at the date of death becomes your new cost base, a valuable opportunity if handled correctly. But misuse the valuation, and you could lose that advantage.

Turning inheritance into opportunity

The smartest approach is to treat an inheritance like any other major financial transaction by planning before you act.

Seek early advice from a qualified tax or estate specialist before transferring, renting, or selling the property. The right timing can make a big difference, not just in terms of market conditions, but also your personal income position, as the year in which you sell can directly impact your overall tax rate.

A bit of structure upfront can transform a potential tax trap into a smooth, well-planned transfer of family wealth. Inheritance should be about preserving legacy, not creating liability, and understanding taxes such as CGT Event E7, and applying the right strategy that’s relevant to you, is how you keep it that way.