Of all the assets you can leave to your children, your home may be the most personal. Whether it’s the house in which they grew up or a much-loved vacation home, transferring ownership allows your children to retain the property and to make new memories there. Like all types of wealth transfers, planning is the key. Transferring a home to your children can trigger all sorts of estate and gift tax issues. Avoid adverse consequences by talking through the various options with your attorneys.
Wealth Transfer with a Life Estate
A life estate is one tool that homeowners often use as part of wealth transfer planning. A life estate results in joint ownership of the property by the parent and child. The parent retains the right to stay in the home until their death. During that time the parent is responsible for all the costs of maintaining the property. The child (“remainderman”) has an ownership interest in the home while their parent is alive, but takes possession of the home only upon their parent’s death.
There are a number of benefits to using a life estate. Because the child has an ownership interest, the property transfer does not have to go through probate when the parent dies. The parent maintains control of the property throughout the parent’s lifetime, and may, for example, rent it out an income property. For the child, inheriting a home through a life estate can have big tax advantages. The child gets a step-up in the tax basis of the home. What this means is that when the child sells the property, the capital gain tax will be calculated on the difference between sale price and the fair market value of the property at the time of the parent’s death. If the property were sold by the parent, the tax would be the difference between the amount the parent paid to purchase the property and the sales price (so that if you sell your home and leave the money to your child, your child is very likely to receive less value).
As for downsides, a life estate does mean the parent no longer has total control of the home. If the parent wants to sell or refinance the home, the parent will need the child’s permission. And if the parent does sell the home, the parent and child may share the capital gains tax burden.
Using a Qualified Personal Residence Trust (QPRT)
Transferring property with a QPRT is another potentially tax-advantaged estate planning strategy, but it comes with some risks. QPRTs are complicated. When structured properly, they essentially allow parents to give a home to their kids in a way that minimizes gift and estate taxes. A homeowner who transfers their home into this kind of trust may remove the home from their taxable estate. The trust establishes a term length, during which the homeowner can stay in the house. When the term ends, the beneficiaries named in the trust take ownership of the property.
Because a parent who puts their home into a QPRT is making a lifetime gift to their children, the parent will utilize a portion of their federal estate tax exemption. In addition, any appreciation in value will not be included in the parents estate when they pass away.
As noted, however, there are risks. If the parent dies before the term ends, the home’s value is added back into the parent’s estate and counts toward the estate tax bill. In addition, there can be family tension when parents outlive the trust term. Suddenly Mom and Dad have to pay rent to their kids to keep living in their own home, or the child who gets the family’s vacation home decides not to let anyone else use it.
In short, these trusts can be useful, but are tricky and a lot of personal issues may need to be addressed in determining whether a QPRT makes sense for any given family.
Selling the Property to Kids
If the parents and children agree on a purchase price, a parent may sell their home to their children. If a parent sells their home to their children at less than fair market value, they will likely be subject to the federal gift tax. A parent who sells a $300,000 property to their child for $100,000 will have to file a gift tax return for the $200,000 difference.
Even if you sell the home to your children, they may not be able to afford the purchase price. It is possible for the parent to loan the money to their children to buy the home. Using a loan allows a parent to sell property to their child without incurring gift taxes, at a rate their child can afford and with minimal interest (the IRS does require that interest is at a minimum set at the applicable federal rate). The parent may be able to structure the loan so that it is canceled on their death and their children don’t owe any additional funds on the parent’s death. The parents should be aware that they may be subject to income tax on the sale as if they sold the property to a third party.
Gifting Property Outright
If your children cannot afford the home and you don’t want to loan money to them, you can still gift your home to your children. Gifting a home outright is a generous gesture that likely triggers the gift tax. Parents can expect to file a gift tax return on the entire value of the property exceeding the annual gift tax exclusion amount ($16,000 for 2022). Parents may be able to apply the federal gift and estate tax exemption (currently $12.06 million) against the gift to avoid paying the gift tax. Such a gift needs to be looked at in the context of the parents overall estate plan.
One big disadvantage of this strategy is that there’s no step-up in basis in the home. When a child inherits property on their parents death, the children’s basis is reset to the date of death value. When a child is gifted an asset, their basis is the same as what their parents’ basis (purchase price plus improvements) was at the time of the gift. This means that the child, when they go to sell the home, may be subject to significant capital gains tax.
Transferring Property at Death
Sometimes parents don’t plan wealth transfers in advance, instead leaving all their property to their kids upon their death. This strategy is easy for the parents (no complicated estate planning decisions!) but creates a burden on the kids. First, assets transferred at death may have to go through probate. It may take many months and a great deal of attorney fees and court costs before the new owner can take possession of the property. When the parent keeps the property in their name up until their death, it’s part of their taxable estate and is subject to estate taxes. In Massachusetts, where the estate tax threshold is just $1 million per individual, most homeowners’ will owe Massachusetts estate taxes if they don’t take steps to remove a home from their estate before death.
One benefit of leaving a home to your child in your will is that your children get a step-up in basis. This will minimize the capital gains your children may pay when they sell the property. (one should note that given there may be a benefit in paying the Massachusetts estate tax when no federal estate tax is due as the capital gains tax may be higher than the Massachusetts estate tax) Another benefit is that the parent maintains control of the assets until their death. Parents should weigh all the pros and cons of the various strategies with their attorneys. The wealth transfer strategy that has the biggest tax savings for one family won’t necessarily be the right strategy for another family.
Sassoon Cymrot, LLC’s team of attorneys advises clients on a wide range of financial planning issues, including estate planning and wealth transfers. Reach out about tax-advantaged ways to keep property in the family. Contact us today.