Got a question about the mechanics of investing, how it fits into your overall financial plan and what strategies can help you make the most out of your money? You can write me at beth.pinsker@marketwatch.com.
Dear Fix My Portfolio,
We own two houses – one is a primary residence and one is a beach house that we use as a secondary home. Could I sell my primary home to a trust and take the $ 500,000 tax exclusion on the profits to avoid capital gains tax, then move to the beach house and make that my primary home? Or, I was told by someone that I could sell my primary residence to one of my children and then take back a note and rent it from them. This way ownership would pass to them, but I would still have an interest in the property. I will probably have to go to a tax attorney to set something like this but was wondering about your thoughts?
Thanks,
J&P
Dear J&P,
How you pass along a house depends on who you want to minimize taxes and logistics for. If you’re just looking to minimize your own taxes because you’ve built up a lot of capital gains in the houses, then you might want to just sell your current primary residence outright to a stranger and move to your beach house. That way, you’d be able to avoid capital gains tax on $ 500,000 of the profit, as you say – $ 250,000 each for you and your spouse. Then, if you live in your beach house for at least two years, it would qualify as your new primary residence and you can figure out what you want to do later with that property.
It’s going to be harder for you to have your cake and eat it too – that is, avoid taxes for yourself, maintain an interest in the houses and also pass the property along to heirs. That will take some doing.
There are many ways to pass on your property, and which you choose depends on your objectives. Think of it as choices along a spectrum.
The bad end
The worst thing to do is nothing. If you own property and you and your wife die without a will – what’s known as intestate – your heirs will be stuck with property they can’t sell right away, but they’ll still have to cover property taxes, upkeep and possibly a mortgage. They’ll have to go through probate, and depending on your family dynamics, that could be expensive and time-consuming.
“There’s a difference between legal title and insurable title,” says John Ross, an elder law attorney at Ross & Shoalmire, based in Texas. There might be an only child left to inherit everything, but they wouldn’t be able to gain clear title to sell the property until the court declared them the rightful heir.
Joint ownership
You can choose some sort of joint ownership provision on both properties, but this usually doesn’t work out in anyone’s best interest financially when a death occurs. Still, it’s a very popular option. On the Estateably platform, which serves estate professionals, some 20% of property handled is in some form of joint tenancy with rights of survivorship structure, says chief executive Ari Brojde.
The trouble with this kind of ownership is that you lose out on a key benefit of passing along a property at death at today’s price, which is known as the step-up in basis. Instead, the gift is based on the fair market value at the time the heir is placed on the deed.
“As a general rule, I highly recommend against it,” says Ross. Some other reasons he gives: losing out on property tax discounts after age 65, asset protection from creditors and Medicaid protection of a primary residence.
Transfer-on-death deeds
Some families choose a transfer-on-death deed, akin to what you would have on a bank account, available in different versions in 31 states. With this kind of deed, property passes automatically to the named beneficiary upon the death of the owner. This avoids the joint tenancy problems, and the asset can pass without probate. “If all I had was a house, using a trust would be overkill in a lot of states,” says Ross, so this kind of deed might be best in that circumstance.
But there are also some drawbacks. “If you’re transferring an asset to heirs immediately on death, there might not be the resources needed to address final expenses, outstanding tax bills, and then that imposes all the obligations on the heirs” says Eric J. Einhart, an officer on the board of directors of the National Academy of Elder Law Attorneys, who practices in New York. Whereas in a trust, your heirs are protected from creditors. There is also often no method to list a contingent beneficiary, which could leave your property in the same as if you died intestate.
Designating transfer in a will
For the 30% or so of people who have a will, many of them will pass on property in it. So, J&P, you can just name your children to inherit your houses that way, and when you are both gone, your kids would probate the will and be able to inherit the houses.
Say you paid $ 50,000 for your primary house and it’s worth $ 550,000 when you die. If you sold it now, you could use your $ 500,000 exclusion and not pay tax. But then you’d have to give it up and move. Instead, you could keep both properties, and when your kids inherit after your death, they would get an asset valued at the stepped-up value of $ 550,000 plus whatever the beach house is worth. If they sold the properties later at a gain from that point, they’d have to deal with the consequences of that on their own.
The trouble with this way is the time it takes to go through probate with a will. If your heirs are not going to sell your houses, they can just plod through it. But if they wanted to put them on the market, they could be jammed up from selling for several months to more than a year.
“People think that if they have passed property in a will, they’ve avoided the probate process. They’ve made it simpler, but it’s still a process,” says Ross.
Getting creative with trusts
The most efficient way to pass along your house may be to use a trust of some sort. “If you have a valid trust, and the house is in the trust, it’s done – period,” says Ross.
Most will use a revocable living trust, which places property into a legal structure that you control. You still live in the house and pay the yearly property taxes and all the expenses, and then when you die, the house just goes to the designated beneficiaries at the stepped-up basis.
If you want to pass along the ownership of the house before you die but still maintain an interest in it, you’ll need a more complicated setup. One such structure is called a qualified personal residence trust (QPRT), which in most cases are irrevocable – that means that once you pass on control of the house, you can’t get it back. Also, the value of your gift would be set at the time it goes into the trust, so, depending on when you die, your heirs might not benefit from a step-up in basis when they inherit the house.
“There are all sorts of shenanigans you can do, but you really need to think about what will become of it all,” says Susan Hirshman, director of wealth management at Schwab Wealth Advisory. “You may think your kids want the house, but do they? If your kids just want to sell that home, was all that effort worth it?”
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