Orange County Estate Planning Lawyer Blog
INCOME TAX & PROPERTY TAX TRAP FOR PREMATURE GIFT OF HOUSE
WAYS TO HANDLE THE FAMILY HOME TRANSFER
Retired couples typically have choices about how to pass on the family home. Might they make a mistake and give away the house too soon? They could sell the home and put the cash in the bank and rent. Another way people sometimes handle this is to draw up and record a deed transferring a home now to their children. The logic is that the children are going to get the house anyway so why not just given to them now. The third choice is to continue ownership of the house until both husband and wife have passed away and transfer the house to the children through their will or better yet through their living trust.
TAX SITUATION OF EACH CHOICE
- Sell now. However, if they make more than $500,000 gain on the sale of the house there will be income tax to pay. Also, they would still have to have a place to live which would cost rent and use up part of the gain on the sale. Moreover, selling the house at the present time would give up future appreciation.
- Give it up now. By giving the house to the children at the present time, the couple could still live in the house by making arrangements with the children. However, the income tax basis of the couple would carry over to the children since under the tax laws this is a gift during lifetime. The income tax basis is what the couple paid for the house plus the cost of any documented improvements. When the couple have passed away, the children could sell the house but most likely would have capital gains if the house has gone up in value over what the couple paid. For example, assume the couple paid $200,000 to purchase the house in 1990 and spent 30,000 on remodel costs. That would make their tax basis $230,000. Now supposing the children sell the house in 2016 after their parents are gone and at that time the house is worth $800,000. The children would have reportable capital gains of the difference between $800,000 and $230,000 which is $570,000. Assuming a federal and state tax rate of about 33% combined, there would be about $180,000 tax to be paid. The only way the children could get out of paying most of the tax would be for the children to move into the house, claim it as their personal residence, and utilize the $500,000 exclusion from available to married couples.
2.1 Possible property tax increase of present gift.
The gift of the house to the children may cause the property taxes to increase because any transfer, gift or sale of real estate is a “change in ownership” un-der California law. There may be a parent-child exclusion which could prevent the increase but the exclusion has to be applied for within legal deadlines and the county assessor will examine all the paper-work involved before deciding the exemption applies. Legal counsel should be consulted BEFORE anything is done and before the parents move out to determine if the exemption can apply. Legal counsel should then prepare all the paperwork and forms to minimize potential problems and tax increases. It is not usually possible to go back and revise deeds and transfer and exemption documents after the fact to try and “fix” the situation to get the property taxes back down once the assessor has increased them.
3. Retain it until they pass away — tax problems less likely-best to put into a living trust.. There is an income tax law that causes the tax bases of real estate to increase (“step up”) to the fair market value at date of death. Thus, in the above example where the house tax basis is $230,000, upon the death of the couple the value would go up to the date of death value which in the above example would be $800,000. Their children would then inherit the property with a tax basis of $800,000 and could sell the house the next day for $800,000 with no income tax on the gain. That is because there is no gain by definition under the tax law with the property value being stepped up.
3.1 Possible property tax increase if house is given to the children
California property tax law states that a death of a property owner is a “change in ownership” which will cause the assessed value to increase to the date of death fair market value. The taxes will then increase to approximately 1.2% per year of the new assessed value. Depending upon what happens to the property after property owner’s death there may be an exemption from reassessment that can be applied for. Exemptions must be applied for within 3 years of the death or transferring event on specific forms. The typical exemption is where a spouse dies and the surviving spouse is still the owner of the property whether that be through a living trust or as a surviving joint tenant. Another exemption is known as the parent-child exemption or the parent grandchild exemption. If a parent dies while residing in their home as their principal residence then if their children inherit the home the parent-child exemption may apply. It does not matter what the value of the home was as long as the parent resided there. There is another type of parent-child and grandparent grandchild exclusion which has to do with investment property. The exclusion for investment property is limited to the first $1 million in value of investment property.
3.2 Dangers In Application Of The Exemptions. The parent-child exclusion and grandparent-grandchild exclusion from reassessment are governed by complicated laws and assessor regulations. Any situation needs to be carefully analyzed BEFORE the change in ownership occurs if possible. As an example, if the property is to be transferred on death through a will or a trust, then the will or trust must be properly worded to fit the family circumstances or else the exemption may not work. An estate planning lawyer should review the financial and legal situation prior to death so that any necessary changes to the will or trust and other recommendations can be made. If a trust or will is involved, the county assessor will review those documents when the exemption is applied for so they need to be correct to not give the assessor an excuse to reassess.
A very typical situation is where a parent has a will or trust leaving his/her estate to her 3 children but actually wants one of the children to get the house. If the house is the only asset of the estate and one of the children gets the house deeded to him or her as part of the after-death administration, (figuring that the others will get paid their share later) the county will say that the parent-child exclusion does not apply to 2/3rds of the house.
If the will or trust does not fit the situation and is not fixed before death, then the situation may or may not be fixable, depending upon various factors. Some steps may be able to be taken to save the exemption if an estate planning lawyer with experience in this area is retained to analyze the situation and recommend the proper steps and documents needed, including possibly going to court. Possible solutions go beyond the scope of this article. It is extremely important to consult estate planning/estate administration lawyers IMMEDIATELY after the death of the property owner and BEFORE filing any papers with the county or state so that the situation does not become worse. Generally the longer one waits to address the situation, the worse it gets because the county will eventually find out about the death and will initiate reassessment procedures on its own.
WHAT ABOUT PUTTING THE HOUSE IN JOINT TENANCY WITH THE CHILDREN?
Joint tenancy is a form of ownership whereby upon the death of one the other owner succeeds to 100% ownership. People sometimes do this thinking it will eliminate having to bother with trusts, wills or any type of estate planning. However, the tax law says that if you put a property in joint tenancy with someone you have made a gift of one half of it at that time and the tax basis of the half given carries over. Thus, in the above example, if the property with the tax basis of 230,000 put into the names of the parents and the children in joint tenancy, the tax law would say that the children received a gift of half of the property with the tax basis of $115,000. If the children outlived the parents, and inherit the property of the parents, they would only be inheriting one- half of the property and only the half inherited would step up in basis. The children would have the basis of the half gifted from the parents of $115,000. They would add that to the $400,000 in value of half of the property inherited at the parents’ passing. So the tax basis would be $400,000 plus $115,000 for a total of $515,000. A sale at $800,000 would cause a taxable gain of $285,000. At tax rate of roughly 33% it would be about $94,000 of income tax due on the sale.
CALL (949) 851-1771 to speak with Lawyer David L. Crockett
CONCLUSION
Before making any gifts, sales, or transfers of a personal residence, a qualified tax attorney or CPA should be consulted to chart out what the taxes would be in each type of situation. Once a transaction has been done, it cannot be unwound. Tax planning has to be done in advance.
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