Many parents consider gifting their home to children either during lifetime or after death. However, this process involves more than just transferring the title. Understanding the tax implications and planning can help avoid unnecessary costs.
Gifting Real Estate During Lifetime
Did you know you can give a property to someone while you’re still alive without worrying much about taxes?
As of 2024, each person has a hefty $13.61 million federal gift and estate tax exemption. Plus, every year, you can give away up to $18,000 to as many people as you like without even touching this big exemption.
Let’s break it down with an example. Imagine you and your spouse want to gift your child and their spouse a house worth $500,000. Each of you can give $18,000 to both your child and their spouse, adding up to $72,000 in total. Now, since the house’s value is way under the $13.61 million cap, you won’t owe any gift tax. But, keep in mind, this gift will slightly lower your lifetime exemption by the house’s value minus the $72,000 you gifted.
Transferring Real Estate After Passing Away
When someone passes away, their real estate often goes through a legal process called probate, just like other belongings. Probate decides who gets what, but it can be a bit of a headache and doesn’t always work out the way you’d hope. That’s why many people try to sidestep this by putting their property into a trust. This way, they have more control over who gets the property after they’re gone.
Some people try a different route by adding their child’s name to the property deed while they’re still alive, thinking it will skip the probate process and the property will automatically go to their children when they pass away. It sounds simple, but there’s a catch. When you add your child’s name to the deed, it’s actually considered a gift. This needs to be reported, though you might not pay any tax due to exemptions, as we discussed earlier.
Adding the child’s name to the deed can also lead to unintended complications. In many states, if you’re not married and own property together, you’re considered ‘tenants in common.’ This means if one owner dies, their share of the property doesn’t automatically go to the other owner. Instead, it gets passed down to their heirs through probate, just like it would have without their name on the deed. This could be a surprise to many who believe adding a child to the deed simplifies things.
It is easy to unknowingly create a “tenants in common” situation, as explained in this LawBits video: The House Deed Dilemma: How One Simple Mistake Could Cost You Big!
Owning Real Estate as Joint Tenants with Right of Survivorship
Continuing from our previous discussion about gifting property and dealing with probate, there’s another approach worth considering: owning properties as joint tenants with the right of survivorship. This choice ensures that if one owner dies, their share automatically goes to the surviving joint owner, bypassing the probate process entirely. It’s a smooth, direct transfer that keeps things out of court.
We previously talked about adding someone to the property deed being considered a gift. This applies here, too. When you add your children as joint tenants, it’s not just a paperwork change; it’s a gift and it needs to be reported as such. But beyond the immediate implications, there is a future tax consequence for your children when you add them to the deed as a joint owner, particularly concerning the concept of “step-up in basis.” In essence, the “step-up basis” means that the value of the property for the tax purposes is “stepped up” to its fair market value at the time of the original owner’s death.
Here’s how it works: Imagine you bought your house for $20,000, and now it is worth $200,000. Upon your death, your half of the property would be stepped up to its current market value. If the house is still worth $200,000 at the time of your death, your half of the property (worth $100,000) would be stepped up from its original cost basis of $10,000 to $100,000. This means that if your child decides to sell the house after your death, they would only owe capital gains tax on the appreciation of your half of the property from $100,000 (the stepped-up basis) to its selling price.
For the other half of the property that your child already owned before your death, the cost basis remains at $10,000 (half of your original purchase price). Therefore, they would owe capital gains tax on the difference between this basis and the selling price of their half of the property.
This partial step-up in basis can still result in significant tax savings, but it’s less advantageous than if the entire property had a step-up in basis, which would be the case if the property was inherited rather than gifted during the owner’s lifetime.
Pass on properties Through a Will
Another solution would be passing a property to your children through your will.
If your children inherit the property under the same conditions as above and decide to sell, they would now pay completely no tax on the sale. The tax is calculated from the property’s value at the time of inheritance, which in this case is the current market value of $200,000. It is crucial to note, however, that the total value of your estate must fall beneath the gift and estate tax exemption threshold to avoid estate tax liabilities. As of 2024, this exemption amount is set at $13.61 million, This rise in exemption allows for more substantial estate transfers without incurring estate taxes.
Holding Real Estate in a Corporation vs. LLC
Owning real estate through a corporation is a popular method, owing to the liability protection it provides. However, there are several misconceptions concerning the probate process in regards to corporately owned real estate. Unless there is a clear corporate succession plan, the corporation’s shares, and therefore the real estate, are subject to probate following the owner’s death.
A Limited Liability Company (LLC) is often the preferred structure for acquiring real estate. LLCs, unlike C-corporations, do not face certain tax problems. Real estate held in a C-Corporation is subject to double taxation upon sale: first at the corporate level, and then again when earnings are paid to shareholders. Furthermore, C-Corporations do not benefit from lower capital gains tax rates on real estate.
The principal advantage of an LLC in real estate ownership is its tax treatment following the owner’s death. Properties within an LLC receive a step-up in basis to their fair market value at death. This means that beneficiaries can sell the property without paying capital gains taxes on the appreciation earned during the original owner’s lifetime. In contrast, when real estate is held by a corporation, only the corporation’s stock receives a basis increase to fair market value. The actual real estate within the corporation does not. As a result, the recipients are in a difficult position. Selling real estate directly results in income tax, whereas selling corporate stock may not be a realistic or desired option. This difference underscores the necessity of choosing the right ownership structure for real estate to achieve tax efficiency and ease of transfer in estate planning.
Utilizing a Revocable Living Trust for Real Estate Transfer
For those aiming to leave property to their children while bypassing the probate process, establishing a revocable living trust is a good strategic approach. By placing the property into a trust and designating your children as the beneficiaries, you can streamline the transfer of assets upon your passing.
Benefits of a Revocable Living Trust
A revocable living trust offers several advantages:
- Flexibility: As the grantor, you can alter or revoke the trust at any time during your lifetime, allowing you to adapt to changing circumstances.
- Probate Avoidance: Assets held within the trust are transferred directly to the beneficiaries without the need for probate, saving time and reducing legal expenses.
- Step-Up in Basis: Upon your death, the real estate within the trust receives a full step-up in basis to the fair market value, minimizing the capital gains tax burden for your children when they sell the property.
How a Revocable Living Trust Works
To establish a revocable living trust, you must:
- Create the trust document, specifying the trustee, successor trustee, and beneficiaries.
- Transfer the title of the property into the trust’s name, effectively funding the trust.
- Maintain control over the trust assets during your lifetime, with the ability to use and manage the property as you see fit.
Upon your death, the trust becomes irrevocable, and the property is transferred to the beneficiaries according to the terms you’ve set forth, all while avoiding the probate process.
In summary, using a trust to hold real estate not only simplifies the transfer process to beneficiaries but also provides substantial tax advantages, both in terms of estate tax savings and capital gains tax mitigation. This makes trusts an attractive option for those seeking an efficient and tax-effective way to pass real estate to their children.
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 financial security for your family.
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