Problem #1: Capital Gains Taxes
Capital gains taxes are wrapped up in the idea of "basis." Generally speaking, if you sell an asset for more than your "basis," then capital gains taxes are owed. When it comes to real estate, your basis in your property is generally your purchase price. However, after your death, the basis in the property is adjusted or "stepped up" to the value of the property as of your date of death. Consequently, when your children inherit the home after your death, their basis in the property is the value of the home as of your date of death, not the original purchase price.
With the way real estate values in our area have soared in the last year or two, the step-up in basis saves your children on capital gains taxes when they later sell the property.
But, if you add your children onto the deed while you are still living, the children do not receive the step-up in basis upon your death. Instead, their basis in the property is the same as your basis in the property (i.e., the purchase price). This is what is referred to as "carryover basis," which has significant impact on the taxes owed when the house is later sold.
Here's a basic example:
Mom buys home in 1998 for $180,000. When Mom dies in 2022, that property is appraised for $480,000. If her daughter inherits the property from Mom following her death, she inherits it at the $480,000 value. When daughter sells it six months later for $500,000, the only tax obligation the daughter has is on the $20,000 of growth in value over the six months since Mom's death.
If, on the other hand, Mom adds her daughter onto the deed in 2018, there will be no step-up in basis applied when Mom dies in 2022. The daughter's basis in the property is the same as Mom's: $180,000. When daughter sells the property for $500,000 six months after Mom's death, she will pay capital gains taxes on the $320,000 of growth in value since 1998 ($500,000 sales price - $180,000 basis = $320,000 subject to capital gains tax). If daughter inherits, she pays tax on $20,000. If daughter is added to the deed during life, she pays tax on $320,000.
Which sounds better to you?
Problem #2: Gift Tax
Capital gains tax is not the only tax issue created by adding your child onto your property deed. You also need to be concerned about gift tax!
When you add a child to your deed, you have made a gift to your child. And, that gift can be taxed! Under federal law in 2022, gifts to an individual in excess of $16,000 during the calendar year are subject to gift tax (in 2023, this amount will increase to $17,000). You can hardly buy an empty lot around our area for $16,000, much less a home! So, certainly, adding your child to your deed is going to be a gift worth more than the amount allowed tax-free under federal law.
Let's look again at the situation with Mom and Daughter from the capital gains tax discussion. Suppose when Mom adds Daughter to the Deed in 2018, the value of the house was $380,000 and the gift tax exclusion amount was $15,000. Thus, Mom has made a $380,000 gift to her daughter, the first $15,000 of which was tax-free. The remaining $365,000 is taxable to Mom.
The tax rate ranges from 18% to 40%, and it is YOU (the giver) who pays the tax. There are strategies to help alleviate Mom's tax burden, but it involves "borrowing" from the amount she is allowed to pass tax-free to her heirs at her death. Also, there is a special IRS tax form (Form 709) that has to be completed to document the gift and to calculate any gift tax obligation.
Do you really want to file another tax return?
Problem #3: Creditor Implications
Adding your child to your property deed makes them a co-owner of the property, which means you have just exposed your home to all of your child's creditors. Is your child behind on their student loans? Are they being hounded by debt collectors? Do they use their Visa card to pay their American Express bill?
Do you want your home to be subject to your child's bankruptcy proceedings, tax liens, or other legal judgments (such as child support arrears, past-due alimony, or substantial civil judgments)?
In addition, now that your child has an ownership interest in your property, he or she could use your home as collateral on a loan without your knowledge. Now, if your child lacks the ability to make those loan payments, you are at risk of losing your home.
Do you really want your house to be at risk for your child's debts?
People generally have good intentions when adding their kids onto property deeds, but many are opening Pandora's Box without even realizing it! If you are considering taking this step, please talk to us first. Let's discuss what problem you are trying to solve by adding your child to your deed. There's a likely better way to address the issue.
Stay tuned for more on this topic in December!
