We see it all the time as parents get older, they decide that they want to give their kids their real estate before they pass on or put them on title as joint tenants. Usually the rationalize this decision by believing that gifting their property to their kids while they are alive will avoid estate taxes, help them qualify for government benefits such as Medi-Cal or simply to avoid probate. While these lifetime gifts can accomplish these goals, there are significant negative consequences of doing such transfers including;
- Loss of your home: Often a parent who is still living in their home will gift it to their children. Unfortunately by doing so, the home could be sold out from under them because of debt owed by their children or the children themselves decide to sell the property.
- Loss of Stepped Up Tax Basis: One of the benefits of inheriting highly-appreciated property is that you get a 100% stepped up basis in that property. In other words, whatever the property is worth when your parents pass on, is what the IRS considers you having paid for the property. Thus when you sell the property, you will owe little or no capital gains taxes. If you receive a property as a gift you get a carryover basis in the property (what your parents paid for the property) and thus when you sell the property you could have a large capital gains tax liability.
- Gift Taxes: Gift taxes are paid by the donor at the time the gift is made. If you give anyone more than $13,000 in a calendar year, you are required to report the transaction as a gift to the IRS. During your lifetime you are allowed to give away 1 million dollars without paying the tax (45% of the value of the gift). However, whatever amount of the exemption you use during your lifetime will be deducted from your estate tax exemption. Thus if you give away 1 million dollars during your lifetime and pass on when the estate tax exemption is 3.5 million, you will only have a 2.5 million dollar exemption. Every dollar above 2.5 million will be taxed at 45%.
Assuming there are no other compelling reasons to gift your homes to your kids, they typically will be much better off if you simply create a living trust or an irrevocable personal residence trust (to avoid Medi-Cal Estate Recovery Lien), transfer the property to the trust and then make their kids the beneficiary. The property will goto their kids with minimal tax consequences and avoid the high cost and delays of probate.