An IRS audit on inherited property is not uncommon. The IRS frequently asks for verification on values of such property. When you inherit any property (specifically some form of real estate), you are not liable to tax on the property at the time of inheritance. This means you will not have to pay taxes based on the appreciated value of the property from the time the original owner bought it until the time of his or her death. The inherited property is given a value which is the fair market value of the property at the time you inherited it. This value forms the stepped-up basis of any calculation of taxes on the gain or loss of the property when you sell it. Click here to read or watch more IRS Help resources.
The thing you should bear in mind is that the property value is not a stagnant figure despite the demise of the original owner of the property. In other words, as time elapses after the demise of the owner, the property should either appreciate or depreciate in value. The former is more likely than the latter. Thus when you sell the property that you inherited, its value would likely be different from what it was when you inherited it.
If you sell the inherited property immediately upon inheriting it, then you do not have to pay any taxes. But it is more likely that heirs keep the inherited property until such time they need to sell it or when they think the price is right to sell, in which case the value of the property would likely have increased from its value at the time they inherited it. When you make such a sale, you are liable to taxes on the appreciated value.
The IRS often checks to make sure the amount of taxes paid on such a sale is correct. The problem comes when determining the value of the property at the time of death (i.e. at the time you inherited the property) which could have been many years before you actually sell the property. And this is often the point of contention between the IRS and heirs who sell inherited property because the amount of taxes is based on the profit made that is the difference between the sale price and the value of the property at the time it was inherited.
The best way to respond to IRS queries is to have a certified appraisal by a valuer on the property that confirms the value at the point of death. If there was an incident close to the time of death related to the property, it can be used to estimate the value of the property at the point of death. For example, if someone made an offer to buy the property 3 years after you inherited it, then the offer price can be used to determine the value of the property at the point of death.
If you cannot get a certified appraisal, you should bring to the table any form of documentary evidence you can to show the value of the property at the point of death. This would help to prove your case. If this fails, you can make an audit appeal.