If two siblings inherit a house from their deceased brother - must they pay taxes on market value even if they live in house?

I agree with the other attorneys. You seem to be mixing up the property tax issue, with the income tax issue, and do not even mention the possible estate tax issue.

The house will be assessed for property tax purposes, because there is no exemption for siblings.

Next, the house steps up in basis to fair market value at the date of your brother's death. Their is no taxable event until the property has actually been sold for income tax purposes. Then when a sale occurs, your tax basis will start with the fair market value of the property at the date of your brother's death.

If your brother has a taxable estate (exceeds $3.5 Million), then an estate tax return will need to be filed.

Any individual seeking legal advice for their own situation should retain their own legal counsel as this response provides information that is general in nature and not specific to any person's unique situation. Circular 230 Disclaimer - Advice given in this response cannot be used to eliminate penalties with the IRS or any other governmental agency.

First, you ask "must they pay taxes on market value even if they live in house?" To be clear, if there is a taxable estate, then "yes," the estate tax is calculated based on the fair market value. Whether the estate is large enough to cause a tax to be due is a separate question. For example, is the deceased sibling's estate larger than $3.5 million?

Second, the focus of your question seems to be on capital gains. Property acquired from a decedent receives a date of death fair market value basis. IRC Section 1014. That means if you sold it for the date of death fair market value there would be no taxable gain. If you sell it for a value greater than the date of death fair market value, there will be a taxable gain.

Third, one way to avoid the capital gains tax would be to reside in the residence long enough for it to qualify as your principal residence. Then sell it and the first $500,000 ($250,000 per sibling) would be elgible for exclusion under IRC Section 121.

Fourth, another approach would be to convert the residence to a rental for a year or two. Then sell it in a tax deferred exchange and acquire an apartment building or other investment property. See IRC Section 1031.

In any event, you need to initially retain a competent local certified public accountant. If you do not have one, get a referral from a friend, neighbor or business colleague. Otherwise, call the local CPA Society office. You may also need a local tax attorney. However, the CPA will be able to refer you to an appropriate person. These are not the types of questions for which you should seek answers over the internet.