One of the ways families build wealth across generations is through home ownership. Parents who can afford to give a property to children who either sell the home and distribute profits or keep it in the family have a definite advantage over generations of renters. How to transfer the home is not always straightforward. A recent article from The Washington Post titled “Don’t put your kids on the title of your home. There’s a better way for them to inherit the property” explains one way to do this.
In this article, the mother placed an adult child on the deed to a home purchased several years ago. The mom wants to sell the house and buy a smaller one nearby. The adult child has never lived in the home. The mother wants to do an 80/20 split of profits from the sale, with the child receiving the majority amount. This would push the child into a higher tax bracket, although the child says she could use the income.
The mother, despite her good will, has made a classic estate planning mistake. Was she trying to avoid probate at death, or to give the child some or all of the property?
As the sole individual homeowner, the mother could have excluded the first $250,000 in profits from federal income taxes on her residence. If she were married, that number would be up to $500,000. However, in this case she’s not the sole owner.
When a person dies, heirs inherit real estate at its current market value. If the home was purchased for $100,000 and its worth is $500,000 when the owner dies, a child who inherits the home outright and then sells it immediately will receive about $400,000 in profits. If the house was inherited after death and then sold shortly thereafter, the IRS would say the profit is $500,000.
If someone inherits a home worth $500,000 and then sells it for $500,000, there is no profit because of the stepped-up value of the home assigned at the time of the owner’s death. However, if the estate in total is worth less than $11.7 million, estate taxes are not a concern.
Here’s the rub: if the mother and child are co-owners of the home and the mother dies, the child inherits only one-half the value of the home (and receives the stepped-up basis for the half but won’t benefit from the stepped-up basis) If the child sells the home, they won’t pay taxes on the share inherited from the mother but would pay taxes on the child’s share of the home.
If the mom bought the house for $100,000 and the mother and child are co-owners, the child would inherit the mother’s half of the property at the stepped-up basis of $500,000. When the home was sold, the mother’s half is shielded from taxes, but the child’s profit is calculated based on the difference between the purchase and sales price, or $400,000, of which their share is $200,000. They would owe taxes on the $200,000, instead of inheriting the home tax-free.
There are many estate planning and real estate tax rules making this more complicated. However, one better alternative is for the mom to put the home in a revocable living trust (RLT), so she controls the home while she is alive, and the child can inherit the home through the trust upon her death.
There’s another option that the article from WaPo doesn’t talk about. If Mom is trying to protect the home from a possible nursing home bill in the future, another option would be to put the home in a special type of irrevocable trust called a Medicaid Asset Protection Trust (MAPT). This would protect the home while still allowing the child to inherit it at mom’s death.
Besides the obvious irrevocable vs. revocable distinction, the differences between a MAPT and an RLT will determine which one is the right choice for you. To get help deciding on the right approach, schedule a short call with me by visiting www.huizengalaw.com/book-a-call
Reference: The Washington Post (Oct. 20, 2021) “Don’t put your kids on the title of your home. There’s a better way for them to inherit the property.”