by John Frederick “Fred” Kempf, Jr.
As an attorney whose practice often involves real estate, real estate titles, estate planning and probate, I have encountered a number of situations where one or both parents propose to use a deed to give their home to their children, or have already done so, with the goal being to let the property go to the children, and at the same time avoid the need for a future probate when the last of the parents has died. Such a transfer can be both a blessing and a curse to the children. The caution is that such a deed can have some surprise unwanted tax consequences for the children, and some unforeseen risks for the parents.
The possible benefits of such an approach can be several. On the one hand, this approach can avoid a need for the children to deal with probate as to that property, once the last of the parents has died. If the parents have already deeded the house to their children, then when they die, there is no interest in the house left in the name of the parent or parents, and the children are already the owners of the property. There is thus no need for a probate, at least as to the house. The children are free to sell the house as their own property, and without further complications from the parents’ end. Sometimes the parents deed the house to their children, let the children assume the financial responsibilities of paying for maintenance, repairs, home insurance, and taxes on the house, but the parents remain as the occupants of the house. That way, the parents can live there with no further responsibilities for the house, the kids see that the house is maintained for their parents’ benefit, and the kids end up as the owners of the house, with a more likely expectation that when the parents have died or are no longer able to live there, the children will sell the house and divide the proceeds from the sale. In some instances, the parents and children are in agreement that as soon as the house is deeded to the children, they are free to sell it at any time. Sometimes the parents deed the house to the kids for them to sell, and use the proceeds to pay for future care of the parents.
While there are some possible benefits from this approach, there are also some significant risks and drawbacks. One of the greatest problems is that such a deed from the parents can result in the children having to pay a significant amount of taxes when they sell the house Mom and Dad deeded to them. I often tell my clients that “Tax is a four-letter word that I cannot spell”, but based on conversations with several of our tax attorneys, here is my understanding of some of the possible tax consequences of such a deed.
If the parents deed the property to their children for no money or other consideration, the law views this as a “gift”. From an income tax standpoint, real estate has a “tax basis”, based on what was paid for the property, or its value at the time it was acquired from another. When the parents deed their house to their children as a gift, the property’s tax basis is the amount the parents paid when they acquired the property (possibly increased by documented amounts actually expended later to improve the house and its value). On the other hand, if the ownership of the property does not pass to the children until the last of the parents has died, then at that point, the children would be able to take advantage of the tax laws, which provide that when the last parent dies, and property passes upon death to their successors, that property passes with a “stepped up tax basis”, meaning the tax laws allow that property to pass to the children at the current fair market value as of the date of the last parent’s death.
To show the importance of the tax basis to this type of deed and the consequences it can have for the children, suppose Mom and Dad purchased a home in 1975 for $50,000. Suppose in 2016, that home has increased to a current fair market value of $250,000. If while living, Mom and Dad deed the house to the children as a gift, and for no consideration, then the children take title to that house based on the tax basis the parents have, which even in 2016, is still $50,000. Let us further suppose the children sell that house later in 2016, for $250,000. When the time comes for the children to sell the house under those circumstances, they will have a “taxable gain” of $200,000, which is the difference between the tax basis amount and the actual sale price. In that scenario, the children’s taxable gain of $200,000 could be subject to federal and possibly state capital gains taxes (with a few limited exceptions). In this example, the children will potentially have to pay capital gains taxes on the $200,000 taxable gain, meaning the children would end up with less net dollars from that sale, after they have paid those taxes.
Next consider an illustration of what happens if the parents do NOT deed their house to the children while living, and instead wait until the last of them dies to transfer ownership of the house to the children. Here we see the importance the stepped up tax basis can have for the children at that time. Suppose Mom and Dad keep title to the house in their names, then Dad dies, and title remains in Mom’s name only. When Mom dies, whether through a will, a trust agreement, or by Oklahoma’s laws of intestate succession (which dictate what happens to our property if we leave no will, trust or other legally binding direction for who receives our property when we die), Mom has left the property to her children or if there is intestate succession, then the children are her lawful successors. In each of these situations, the house passes upon Mom’s death to her children. Suppose the parents purchased a home in 1975 for $50,000. Dad dies first, and title remains solely in Mom’s name. Then, in 2016, when Mom dies, that home has increased to a current fair market value of $250,000. In that case, if the house passes to the children AFTER Mom’s death, then the children’s stepped up tax basis in the house in 2016 will be $250,000. If the children acquire title under these circumstances, when they sell the house in 2016 for $250,000, they have the stepped up tax basis of $250,000, and thus, there is no taxable gain on the sale of the house for that amount. That means the Children keep all of the $250,000, without having to pay any capital gains taxes on those sale proceeds. As these examples show, if one of the goals of parents in deeding property to their children is to see that they can sell the house and keep the money, from a tax standpoint, it will be better for the children to wait to receive title to the property until after both Mom and Dad have passed, and not before.
Another consequence of a deed from parents to children while the parents are still living is that at that point, the parents have given up all control over the property. Suppose the parents deed the home to their children, but expect the children to allow them to continue to live there for the rest of their lives, and for the children to keep the house in good condition. Many parents have full trust that if they deed the property to their children, their children will see that the property will still be preserved by the children for the benefit of the parents. However, what happens if the children are less than honorable toward their parents and decide to sell the house, and move the parents out? Or what happens if the parents deed to the children, but the children have a money judgment assessed against them and a creditor comes after that property to satisfy the judgment against the children. Or what happens if the children take out a loan, mortgage the property, default on the loan and the property is foreclosed. Or what happens if the house was deeded to a child to assure they would use it for the care of the parents, but the child dies, and the child’s spouse, who has no concern for the parents, ends up with the house as their own property. In each of these situations, the parents may well have lost any ability to control these unexpected problems.
Such a transfer by the parents can have still other consequences, such as limiting or delaying the ability of a parent to qualify for Medicaid benefits. Like jumping into a swimming hole, it is always best to look before we leap. Before parents decide to deed their home to their children, they should give these matters careful consideration, and perhaps discuss them with their attorney. There may be advantages to parents trying to address the transfer of their home to the children after their death through a will or a trust. Preparing a will or a trust agreement both involve more time and expense than a simple deed. A will costs less to create than a trust, but a will could create the need for a future probate proceeding. Trusts cost more to create, but can avoid the need for a probate. Whether a parent leaves a house to children in a will, through a trust, or even through the laws of intestate succession, any of these approaches may ultimately allow a parent to leave a better benefit to the children after the parents are gone, and without an unexpected tax bill for the kids. It may also leave the parents in control of their property until that time.
For more information on probates, please contact Fred Kempf at 272-9241 or firstname.lastname@example.org.
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Posted on Mon, May 2, 2016
by Andrews Davis filed under