What to Know About the Tax Implications of Inherited Property in Arizona

Inheriting property in Arizona often comes with more tax complexity than expected. Basis adjustments, ownership structure, prior depreciation and how the property is reported after transfer can affect tax obligations. Misunderstanding any one of these areas can create unnecessary tax exposure when the property is sold, rented or divided among heirs.

Arizona does not impose a state inheritance tax, but federal rules still apply, and reporting errors are common, especially when multiple heirs or properties are involved.

Stepped-Up Basis and Why It Matters

One of the most important tax concepts tied to inherited property is the stepped-up basis. In most cases, the tax basis of inherited property is adjusted to its fair market value as of the decedent’s date of death. This adjustment can significantly reduce capital gains tax if the property is sold.

For example, if a parent purchased a home decades ago for $150,000 and it is worth $600,000 at death, the heir’s starting basis is generally $600,000 rather than the original purchase price. If the property is sold shortly after inheritance for close to that value, capital gains may be minimal or nonexistent.

Arizona follows federal basis rules, so this stepped-up basis applies for both federal and Arizona income tax purposes. Problems arise when heirs fail to document the property’s value at the date of death. Without a defensible valuation, taxpayers may default to an incorrect basis, often overstating taxable gain later.

Partial Step-Ups in Community Property Situations

Arizona is a community property state, so when one spouse dies, community property may receive a full step-up in basis rather than a partial one, depending on how the property was titled and characterized.

Property held jointly outside of community property rules may only receive a step-up on the deceased spouse’s portion. This distinction can materially change future tax outcomes.

Heirs and surviving spouses often assume all inherited property receives the same treatment. That assumption can lead to incorrect basis calculations, especially when properties were acquired before marriage, inherited previously or refinanced over time.

Multi-Heir Ownership and Allocation Challenges

When multiple heirs inherit a single property, tax reporting becomes more complicated. Each heir receives a proportionate share of the stepped-up basis based on their ownership percentage. That allocation must be tracked carefully, especially if one heir buys out another or the property is sold later.

Common issues include:

• Disagreements over valuation at the date of death
• Unequal distributions not properly documented
• One heir using the property while others do not

If the property generates income, each heir is responsible for reporting their share. Improper allocation can result in mismatched reporting and IRS notices, even when total income is correct.

Prior Depreciation Can Change the Outcome

Inherited rental property introduces another often-overlooked issue: prior depreciation. Depreciation taken by the decedent does not carry over to the heir in the same way it would with a gifted property. The stepped-up basis generally resets depreciation going forward.

However, this does not eliminate all complications. If the property is sold, depreciation recapture rules may still apply depending on how the basis was calculated and how long the heir held the property. Errors often occur when heirs attempt to continue depreciating the property using the decedent’s old schedule rather than establishing a new one.

Failing to reset depreciation correctly can distort income, trigger recapture issues at sale or raise red flags during an audit.

Using the Property After Inheritance

What an heir does with the property after inheritance also affects tax treatment. Converting an inherited home into a rental, selling it or using it as a primary residence all have different implications. For example:

• Renting the property requires setting up depreciation correctly from the stepped-up basis
• Selling the property later requires accurate gain calculations
• Moving into the property may allow for future exclusion planning, but timing matters

Each choice changes the reporting requirements, and mistakes made early can compound over time.

Planning Before a Sale or Transfer in the Greater Phoenix Area

Working with a CPA who understands Arizona property rules and federal tax interaction can help heirs make informed decisions early. H&H Accounting Services assists clients with inherited property planning, basis calculations, depreciation strategy and multi-heir reporting issues.

Contact us at (480) 561-5805 to discuss your situation and make sure your reporting reflects the full tax benefits available to you.