Many parents consider gifting their home to children either during lifetime or after death. It is not as easy as just moving to a house and changing the name in the deed. Gift to children has tax consequences which can be avoided with planning ahead.
Gift Real Estate During Lifetime
If you move out of the house and give it to children today, you are using up unified federal gift and estate tax exemption of $5,45 million (as of 2016) offset by annual gift tax exclusion mount of $14,000 (as of 2016).
Each person can gift up to $14,000 to an unlimited number of people. If you are a couple giving a house valued at $500,000 to a child and his wife. Each person can gift $14,000 to two people separately, totaling in the amount of $56,000. As long as the value of the house is less than $5,45 million, there is no gift tax owed. However, your lifetime exemption will be reduced by the value of the house minus $56,000.
Gift Real Estate After Death
Real estate properties go through a probate in case of the death of its owner just like other properties. Distribution by a probate can often have undesirable results, so many families try to avoid it by owning the property with a corporation or a trust. A will that directs how to distribute properties can prevent undesirable distributions, but it does not avoid a probate.
Another method many families use to pass on property without a probate is to add a child’s name to a property deed during a lifetime. However, this act can often invite more problems than it has avoided.
This is because in many states, when more than one person owns property together and they are not married, the property is owned by tenants in common by default. In this case, if one of the owner dies, his or her ownership share does not transfer to the other owners. It goes to the deceased owner’s heirs through probate.
Own properties as joint tenants with the right of survivorship
This problem can be avoided if the deed lists the property as owned by joint tenants that both have the right of survivorship or similar language signifying survivorship rights. This means surviving owners will inherit the share of the deceased owner outside probate.
However, there are some reasons why you might not want to deed real estate to children even as joint tenants.
One of the biggest reasons is that it has adverse tax consequences because deeding property to children is actually considered a gift.
Therefore, the cost basis of what you paid for your home carries over to your child.
For example, let’s say you paid $20,000 for your home and it is now worth $200,000. You add your children to the deed, which the IRS deems a gift. After you die, the children sell the home for the market value of $200,000. They will be taxed on the profit which is the difference between the cost basis of $20,000 and the sale price of $200,000 – or $180,000, minus the cost of the sale. That’s a big tax burden for your children.
Pass on properties via will
Another solution would be passing a property to your children via your will. When they sell it using the same scenario above, they would owe no tax on the sale because their cost basis is what the property was worth when they inherited it (current market value of $200,000).
However, the total value of your estate has to be below the gift and estate tax exemption amount ($5,45 million as of 2016) in order to pass on properties without owing estate tax.
Own properties in a corporation
Many property owners hold real estate in a corporation because it provides liability protection. The owners believe that passing on real estate in a corporation will avoid probate. However, without a business succession plan or an agreement between partners, the shares of corporation are inherited through a probate.
Limited Liability Company or LLC is the most preferred way of owning real estate. It does not have tax issues of C-corporations. If you hold real estate in a C-Corporation, you are exposed to a double taxation when you sell an appreciated property. The proceeds of sales will be taxed at a corporate level and again when it is distributed to shareholders. In addition, lower capital gains tax rate is not available when real estate is owned by C-Corporation.
One of the biggest reasons you should own real estate in LLC is that properties in LLC get a step up in basis to a fair market value at the time of death. Beneficiaries will incur no capital gain tax when they sell the property. If real estate is owned by C-corporation, only the shares of stock will get a step up to a fair market value, but not the real estate inside the corporation. As a result, beneficiaries cannot sell real estate separately without avoiding double taxation, unless they sell the stock of the corporation.
Own properties in a trust
If your goal is to leave property to children while avoiding probate, you can do so by creating a simple trust and titling the property in the name of the trust, naming your children as trust beneficiaries.
You avoid the problems and costs of gifting properties outright. The properties owned by trust will pass on outside probate in the most tax-efficient way. They will not be counted toward the total estate thus, preserving the exemption amount for other properties. They will also pass on with a step up basis to a fair market value saving children from realizing capital gains.
Qualified Personal Property Trust
Another way that parents can pass on real property is through Qualified Personal Property Trust (QPRT). By putting a property in QPRT, the gift is made to family members while the grantor retains the righ to live in the residence for term of years.
If the value of the house is $500,000, the value of a parent’s right to live in the house will be calculated by IRS based on length of trust term and the parent’s age. Let’s say the right is valued at $300,000. Now, the gift of $200,000 is made with the trust. The future appreciation of property value is disregarded. Therefore, a parent uses $200,000 out of his $5,450,000 exemption at the time of gift. After the end of the term, he can choose to continue to live in the house paying rent to his children (which will reduce the size of his taxable estate). At death, the residence is no longer included in the parent’s estate.
If your own properties in a foreign country, you need to be aware how properties are distributed upon death in the country and often need to have a separate will.
Call our office to schedule a time to talk about a Wealth Planning Session, where we can identify the best ways for you to ensure your legacy of love and financial security for your family.