Adding your children’s name on the deed of your home, commercial property, farmland, or ranch seems like a simple inexpensive way to do your own estate planning. What could go wrong? Right? Well, let’s look a little closer to what happens when you put your children on a deed with you. It might actually cost you much more than you could have ever imagined.
1. Creditor Claims
If your sons or daughters are on the title with you, then their share of the real estate is subject to their own creditor claims. This includes claims from liability, claims stemming from auto or homeowner accidents, credit card companies, lending companies, or business transactions. Moreover, your real property could also be at risk if your sons or daughters are required to pay restitution as a result of criminal consequences. Yes, I’ve seen it happen!
2. Divorce Claim
If one of your children goes through a divorce, the court will divide the divorcing couple’s property as designated under the statute. If your son or daughter is an owner on your real estate, then that portion of your child’s ownership in your real estate is legally your child’s property and subject to division by the court. This equates to your child’s soon-to-be former spouse will be entitled to a share of your real estate. We all want to believe this will never happen to our children; however, divorce rates are as high as 50% according to a simple google search. Regardless, it is a stunning percentage so naming your children on the deed of your real estate is a huge risk for you and them.
3. Title Issues
Adding a child’s name on the title with you gives your child an ownership interest in your real estate. Therefore, the only way to sell or refinance your mortgage is with your child’s permission. What is even scarier is that your child could sell their share of the property without your consent or take you to court to enforce a partition to separate or sell their portion of the real estate. You may think it could never happen to you, but it does happen and can permanently destroy family dynamics.
4. Bankruptcy Claims
Lastly, hundreds of thousands of people file for bankruptcy each year. If your child files bankruptcy, the bankruptcy court may be entitled to his or her share of your home. Remember, by placing their name on your home you are gifting them a share of the property. As a result, your child’s share of your home may be sold to satisfy his or her debts.
5. Income Tax Challenges and the Importance of Step-Up in Basis
Real estate and taxes tend to be complex and very important for you and your children. Specifically, it requires an understanding of capital gains tax. A capital gain is the difference between your purchase price and improvements (your basis) and the sales price of your real estate. For example, if you purchased a home for $100,000 and sold it a few years later for $400,000 you would have to pay capital gains tax on your $300,000 gain unless you meet the IRS’ exclusion test for sale of your primary residence which does not apply in this example.
If you add your child to the title of your home while you are living, your child receives your basis (purchase price plus improvement costs) in the real estate. If your child sells the real estate after you die, your child will likely incur a capital gain tax for the difference between your basis, and the sales price.
Let’s illustrate this in the two examples below.
Example 1: You purchased your real estate in 1990 for $100,000. In 2020, you add your child to the deed when the home is worth $600,000. When you added your child on to your deed, you technically made a gift of one-half the value of the property ($300,000). Your child also receives one-half of your original basis ($50,000). Therefore, when you die and your child sells the home for $600,000, then your child would be liable for a capital gain tax on their $300,000 profit.
Sale Price ……………………. $300,000
Purchase Price (Basis) ………$50,000
At a capital gain rate of 20%, your child’s tax bill is $50,000 on their share of the sale price.
On the other hand, your estate’s share of the home is not subject to capital gains tax because your child would receive a step-up in tax basis upon your death. This means, their basis for your estate share of the home worth $300,000 is stepped up from the original purchase price of $50,000 to $300,000, so the capital gain on the sale of your estate’s share of the home is exempt from capital gains tax.
Sale Price ……………………$300,000
Purchase Price (Basis) ……. $300,000
Gain ………………………………. $0.00
Here you can see your child is responsible for a capital gain tax of $50,000 for their share you gifted to them. Assuming there is no estate tax because your deceased parent’s estate is below the 2022 federal estate exemption of $12.06 million, (and it will increase to $12.92 million in 2023) there is likely no tax on the share from your estate after you pass.
So, what if instead of adding your child as an owner of a portion of your real estate, you created a revocable living trust?
Example 2: You purchased your real estate in 1990 for $100,000. In 2010, you created a revocable living trust which provides your child receives the real estate upon your death. Because under the revocable living trust provisions, 100% of the real estate passes upon your death to your child, your child receives a step-up in tax basis on the entire sale price of the home. Therefore, assuming your child sells the real estate after your death their cost basis is stepped up to the date of death value of $600,000 from the original purchase price of $100,000, so the capital gain tax on the sale of the real estate is zero.
Sale Price ……………………$600,000
Purchase Price (Basis) ……. $600,000
By using the revocable living trust alternative and not adding your child on your deed during your lifetime you are saving them significant capital gain tax. Additionally, using a revocable living trust to hold your child’s inheritance in a separate share for their benefit when you pass, whether it is real estate or other assets, you are protecting them from divorces and creditor claims outlined above.
This is one of many reasons a revocable living trust can be the most important document in your foundational estate plan. Moreover, trust planning is a viable alternative to avoid all the issues described above and you can better protect you and your children during your lifetime and long after you have passed.
Contact our team at Borkuslaw Group today and make a live or online appointment!
Please note that information contained in this news alert is not and should not be construed as legal advice or opinion nor does this information alert create an attorney-client relationship.