Transferring property to children before your death might seem like a straightforward way to simplify estate distribution and avoid probate. However, this decision can have significant financial and tax implications. In particular, doing so can result in the loss of the valuable "step-up in tax basis," potentially saddling your heirs with a substantial tax burden. Let's delve into the details, provide real-world examples, and explore why using a trust may be a better solution to achieve your estate planning goals.
Downfalls of Transferring Property to Children Prior to Death
While giving property to your children during your lifetime can be motivated by generosity, it comes with several potential pitfalls:
- Loss of the Step-Up in Tax Basis
When property is transferred before death, the recipient (your child) inherits the donor's original tax basis in the property. In contrast, when property passes through inheritance, the tax basis is "stepped up" to the property's fair market value at the date of death. Losing this step-up can lead to significantly higher capital gains taxes when the property is eventually sold. - Gift Taxes
Transferring property during your lifetime may be considered a taxable gift. While the lifetime gift tax exemption may shield some transactions, numerous large gifts can reduce the amount of assets excluded from federal estate taxes. Also the gift tax exemption threshold can be amended by Congress, so the current high threshold may not be permanent. - Loss of Control
Once ownership of the property is transferred, you lose legal control over the asset. This can lead to complications if your child wants to sell it, leverage it, or if they encounter legal or financial difficulties (such as divorce or creditor claims). - Medicaid and Asset Protection Concerns
Transferring property outright might impact your Medicaid eligibility if you require long-term care, due to the look-back period for asset transfers.
What Is the Step-Up in Tax Basis?
The step-up in tax basis is a critical tax advantage for inherited property. "Basis" refers to the value used to calculate capital gains or losses when an asset is sold.
When property is inherited, the cost basis is adjusted to its fair market value as of the decedent's date of death. This typically eliminates the gains accrued during the decedent’s ownership from taxation. By contrast, transferring property during one's lifetime means the recipient assumes the giver's original basis.
Example: Loss of Step-Up in Basis
Scenario 1: Transferring Property During Your Lifetime
- Let's say John purchased a home for $100,000 in 1980. Over the years, the property has appreciated to a market value of $500,000.
- John decides to gift the property to his daughter Sarah during his lifetime.
- Sarah then sells the home for its current value of $500,000. Sarah will owe capital gains taxes on $400,000 ($500,000 market value - $100,000 tax basis).
- If Sarah sells the home in 10 years after the property has appreciated to $1,000,000, Sarah would owe capital gain taxes on $900,000.
Scenario 2: Inheriting Property (Transferring Property After Death)
- If John had kept the property until his death and Sarah inherited it, the tax basis would be stepped up to the market value of $500,000 as of that date.
- If Sarah sells the home for $500,000, no capital gains taxes would be due.
- If Sarah sells the home for $1,000,000, Sarah will owe capital gain taxes on only $500,000.
This difference in tax treatment can result in tens (or even hundreds) of thousands of dollars in potential taxes, depending on the applicable capital gains rates.
Why Many Families Lose Financial Benefits Without the Step-Up
For an average individual, missing out on the step-up in tax basis could mean:
- Higher Tax Liability: Heirs may owe a significant portion of the property’s value in capital gains taxes upon sale.
- Reduced Estate Value: The additional tax burden can erode the financial legacy intended for family members.
- Lost Opportunity: Heirs might need to sell property quickly to pay the tax bill, potentially missing out on long-term appreciation.
This is particularly problematic for individuals holding highly appreciated assets, such as homes, vacation properties, or investment real estate.
Considerations for Using a Trust or a Will
To preserve the step-up in tax basis and protect heirs from tax burdens, proactive estate planning is essential. Here are some options to consider:
1. Revocable Living Trusts
A revocable living trust allows you to retain control of your property during your lifetime while ensuring it is transferred upon death. Key benefits include:
- Preservation of Step-Up in Basis: Since the property remains in your possession until death, the step-up applies.
- Avoidance of Probate: The property does not need to go through the lengthy and costly probate process, allowing for near-immediate and private distribution to beneficiaries.
- Control and Flexibility: You maintain control and can modify or revoke the trust during your lifetime.
2. Irrevocable Trusts
In certain cases, an irrevocable trust may be used to achieve asset protection or estate tax benefits. These trusts can offer similar advantages, including preserving the step-up in basis, but restrict your control over the property after it is transferred into the trust.
3. Last Will and Testament
Using a will to outline your intentions ensures your property passes to the intended beneficiaries. Although going through probate may be required, the step-up in tax basis will still apply, minimizing the taxable gain for heirs.
Benefits of Trusts and Wills: A Practical Example
Case Study: Keeping the Step-Up in Basis with a Trust
Emily owns a vacation home purchased for $200,000 that has appreciated to $1 million. If she transfers the home to her son Michael during her lifetime, Michael assumes her $200,000 tax basis. When Michael later sells the home for $1.2 million, he could owe capital gains taxes on $1 million ($1.2 million sale price - $200,000 original basis).
If Emily places the home in a revocable trust and Michael inherits it after her passing, Michael’s basis would step up to $1 million. Selling the property for $1.2 million would only result in taxable gains of $200,000, saving him significant tax liability.
Key Takeaways
- Transferring property to children prior to death often results in the loss of the step-up in tax basis, creating a substantial tax burden for heirs.
- Using estate planning tools such as trusts or wills allows for the preservation of the step-up in basis and ensures a smoother transition of assets to beneficiaries.
- Consulting with a qualified legal and financial professional is essential for creating an estate plan tailored to your family’s needs, ensuring that you avoid unnecessary taxes and preserve your wealth for future generations.
By approaching these decisions with proper knowledge and planning, families can secure their financial future and avoid costly mistakes. Using trusts or wills to protect the step-up in tax basis is one of the most effective strategies for passing on wealth while minimizing tax burdens. Make sure you have the right tools in place to preserve your legacy and enrich the lives of your loved ones.
None of the information contained in this blog post constitutes legal advice from Young & Chic LLP. There are many considerations that you should factor in before transferring property. We recommend setting up a free consultation with one of our experienced attorneys to discuss your unique situation so we can formulate a plan to address your needs.