Giving Real Estate: Many Options, Many Considerations
Written by Dane J. Dehler
Real estate is frequently an important asset in estate planning. Whether the property is an investment asset dear to the client’s heart or a residence where a family member is living, there can be a great deal of emotion involved in deciding what will happen to it. And unlike stocks, bonds, or bank accounts, real estate has inherent liabilities, such as real estate taxes, insurance, maintenance, homeowners’ association dues, and even potential liabilities in lawsuits if someone is hurt on the property.
Clients’ choices for how to handle real estate can be overwhelming. People can, among other options, make a current gift of real estate to a child, put someone else’s name on the title in joint tenancy, or leave it as part of their Will or Revocable Trust. At death, it can be sold, allocated specifically to one individual, or held in a continuing trust that gives a beneficiary a right to live there.
Before examining the options, it’s important to understand the income tax concept of “basis,” which determines how much taxable gain is realized when something is sold. Basis is usually what you originally paid for an asset. If you give an asset such as real estate to someone else when you are alive, they keep the same basis that you had. When they sell it, any gain is based on your original “basis.” It’s much different when you leave an asset to someone at death. If an asset transfers because of the death of the original owner, then the basis is adjusted (usually “stepped up”) to the market value as of the date of death of the original grantor.
A simple example is as follows, if Dad gives you a home that he paid $10.00 for while he is alive, and you sell it after his death for $100.00, you will be required to pay income tax on $90.00 worth of gain. If instead Dad leaves you the same home in his Will, and you sell it right after his death, there’s no gain because of this “step up” in basis. This is an important tax consideration when deciding what to do with real estate.
- Devising the Real Property By Will.
A common way to transfer real property at death is to devise the property by Will. Because your Will is not operative until death, you retain full control over the property and can change your mind at any time by creating a new Will. You can also sell the property or take out a mortgage without anyone else needing to sign off or agree. It’s usually a good income tax result because the basis gets adjusted to the date of death market value, as described above.
A transfer of real estate via Will generally requires a probate proceeding after death, which incurs some legal fees and court costs, and makes the Will a matter of public record. However, if a probate would still be required for other assets, the addition of real estate being part of the process won’t change the cost or underlying administration much at all.
- Execute and Record a Beneficiary Deed.
A simple and convenient method of transferring real property at death is a beneficiary deed. A properly signed and recorded beneficiary deed conveys the real property automatically to the beneficiary on the owner’s death. It’s not effective until death, so the owner can revoke the beneficiary deed at any time he or she wishes. After death the grantee claims the property by filing an Affidavit of Death and certified copy of the grantors death certificate. Additionally, if the owner needs to refinance or sell the property, the beneficiary has no say in that transaction. Because the transfer becomes effective at death, the beneficiary gets the benefit of the stepped up basis. Utilizing a beneficiary deed may eliminate the need to file a probate, at least for the involved real estate, thus saving court costs and legal fees.
However, beneficiary deeds are not without their own pitfalls.
1) A beneficiary deed is not effective until it is recorded. It is not enough to execute a beneficiary deed and then place it in a drawer or estate planning binder. A beneficiary deed must be recorded and must be recorded BEFORE the owner dies.
2) A beneficiary deed remains effective until a revocation is recorded. It is not enough to execute a Will or other writing purporting to revoke the beneficiary deed and giving the property to someone else.
3) If a beneficiary deed transfers property to multiple beneficiaries, the beneficiaries will take the property as tenants in common, unless specified and accepted otherwise. Property ownership by several people (such as a bunch of siblings) is often fraught with difficulties. If one tenant in common wants to keep the property and another wants to sell, the individual who wants to sell may be forced to file a costly lawsuit (commonly referred to as a partition lawsuit). By contrast, a probate, where the Personal Representative can sell the property and divide the proceeds, will end up being a much simpler process when compared to conflicted co-owners through a beneficiary deed.
- Gifting the Home Prior to Death.
Many people will do almost anything to avoid a probate proceeding. One way to avoid it is to gift assets before death. With real property, parcels can be transferred by quitclaim or special warranty deed before death.
But giving property away doesn’t mean you have to move out. If desired, the former owner can then enter into a contract with the new owners (often their children) to lease the property back for the remainder of the former owner’s life.
While an outright transfer may seem like a simple and easy way to transfer real estate, an outright gift also has downsides. When a gift is made to anyone, other than your spouse, of property valued at more than $15,000 ($30,000 per couple) in a calendar year, the IRS requires that a gift tax return (Form 709) be filed. Because the estate tax threshold is currently $11.18 million, this doesn’t actually incur or even later increase any tax for most individuals, but it is a technical requirement.
Additionally, as discussed above, a gifted item keeps the owner’s original basis. If and when the property is sold, especially if it is after the owner’s death, the beneficiary will likely pay more capital gains tax than if he or she had received the property at death.
Also, for care planning purposes, if an individual applies for Medicaid assistance (ALTCS in Arizona) within five years of the gift, the grantor will be ineligible for a period (called a transfer penalty), depending on how much the assets were worth. This can create the worst case scenario where someone in need of full time care has no remaining money or assets, but does not qualify for the Medicaid/ALTCS benefits.
- Title the Real Estate in the Name of a Trust.
Another option for transferring Arizona real property is to create a revocable trust and transfer the property to the trust. If real property is transferred to a trust, it will be disposed of according to the terms of the trust. This option can be ideal because the trust is revocable and can be amended, so the disposition of the real property can be changed without recording new deeds. Moreover, when beneficiaries receive real property from a trust by way of the death of a settlor, the beneficiaries receive the benefit of the stepped up basis, as discussed above. Finally, a revocable trust is a private document. Even after death, the trust does not become public record, and only certain parts of the trust must be shared with beneficiaries.
A trust also is an excellent option if you own real estate in multiple states. All parcels can be transferred into the same trust, avoiding not only a main probate proceeding in the resident state but also proceedings in the other states where property is owned.
However, while a revocable trust does not change your underlying rights to the property in any manner, lenders frequently require a great deal of extra documentation and other complexity when securing a note with trust-owned property. Anyone who’s purchased a home with a loan within the past several years knows how voluminous the paperwork is, and a trust just adds to that. Additionally, a current transfer to a trust may require endorsing your title insurance policy and even updating your homeowners’ insurance. Therefore, a common planning technique is to execute a beneficiary deed INTO trust to avoid some of these concerns, while still avoiding probate and fulfilling other goals of disposition under the trust.
- Sell the House to Your Children.
Another possibility is selling your home to your children. If the home is sold for less than fair market value, the difference between the fair market value of the real estate and the sale price will be considered a gift to the purchaser. Thus, if this gift is more than $15,000.00 ($30,000.00 for couples), a gift tax return should be filed.
Of course, a parent also could sell a home to a child at full market value but not accept all (or any) of the money up front. Instead, a note can be executed at the time of the sale. The note must be in writing and include reasonable interest. After the sale, the parent can then make a $15,000.00 ($30,000.00/couple ) per year gift to the purchaser without having to file a gift tax return, apply the gifted sum to the note, and slowly pay off the underlying note on the property. However, this process can be time consuming, and it can be easy to lose track of the amount of note still payable after the gifts are made. It is also advisable that an attorney and/or accountant be involved to assist during this process.
- Enter Into a Lease-Option Transaction.
In some limited occasions, the owner of desirable real property receives an offer to sell their real property at a time in life when the sale would create large capital gain liability. The property owners could try to swap the property into another investment property using the IRS “like kind exchange” rules (commonly known as a “1031 exchange”).
However, if the property owners want to ensure they receive some cash immediately, they may want to consider a lease/option transaction. In a lease/option transaction, the owner leases the property to the eventual buyer. The owner also grants the eventual buyer an option to purchase the property within a reasonable time after the date of the owner’s death. The eventual buyer typically pays a reasonable cash payment to the owners at the start of the lease, which would be applied against the purchase price when/if the option is exercised. Capital gains taxes are paid on the cash payment only when the option is exercised or lapses. When the owner dies, the tax basis of the property gets adjusted to market value as of the original owner’s date of death. It is then that the option can be exercised by the eventual buyer. With the basis adjustment, most, if not all, of the capital gains taxes should be eliminated.
The downside to this type of a transaction is the complicated layers. If you are interested in a lease/option transaction, you should enlist an attorney for assistance.
These are not the only considerations, of course. Here are a few more: Consider whether the person who is receiving the property wants it and can reasonably afford the property. Often, real property is gifted to individuals who find they do not have the means to stay there. Also, don’t forget to review your insurance to ensure that it is up to date and correct; the entity that owns the property should be named as the beneficiary. (So, if you have a trust, the policy should name the trust.). And if you are transferring real property, always consider purchasing a new title insurance policy, or having your existing policy endorsed to reflect the change.
The bottom line is, if you own real property, you should carefully consider your options. You may have more than you realize.