The home is often the most complex part of an estate planA comprehensive planning perspective from Fidelity’s Viewpoints
For most families, a home is among their most valuable assets, both financially and emotionally. Primary homes and vacation homes are often the most complex parts of an estate plan. Few possessions are wrapped up in so much history and emotion, are worth so much money, and are so complicated to inherit.
“It is important to be thoughtful about how you are going to leave a home and to whom,” says Terri Lyders, an estate planning specialist at Fidelity. “If there are issues between siblings, tax considerations, or other family needs to consider, the parent should make an informed decision about what to do with the house, and ensure that their estate plan reflects these wishes.”
The need for planning
While Fidelity encourages everyone to have a basic estate plan, there are a number of reasons it is particularly important to come up with a specific plan for a home or homes.
Compared with inheriting a stock or bank account, homeownership is complex, with ongoing costs and maintenance.
Many homes come with lots of memories, or may be wrapped up in a family member’s plan for his or her future or current living situation. That can make negotiating decisions about a home very tricky for siblings or others who inherit property.
If the person who inherits the property doesn’t want to keep ownership of it, they may incur legal fees, taxes, and other transaction costs. In addition, many states have estate tax exemption limits far below the federal level. If the value of the home exceeds that limit, the heir may face a state estate tax bill and may have insufficient funds to pay it. That could force a sale of the home or force the heir to seek financing options to pay the bill.
An heir is granted a step-up in basis at the time of death—meaning that if they sell the house, it will be taxed based on the value at the time of death (or alternative valuation date, if allowed). But that basis doesn’t generally transfer.
At the time of inheritance the basis is reset, but if the heirs sell the house—even to another sibling—they will be taxed according to that stepped-up basis.
When there is an outstanding mortgage on the home, careful consideration needs to be given to how the debt will be handled when the home passes to the heirs. Most mortgages have a “due on sale” clause that may be triggered at death. If so, other liquid assets in the estate would need to be used to pay off the debt, the inheritor would need to qualify for a mortgage on their own, or the home would need to be sold.
To prepare for a smooth and efficient transfer of your home, start by thinking about your goals and your financial situation—what you would like to see happen with the house. For instance, does one of your children still live with you, and do you want to provide an option for them to stay in the house for some period of time? Do you have a vacation home you would like to see shared by future generations?
After understanding your goals, be sure to discuss your plan with your family. You need to be understanding if your children have different ideas about whether they would want to live in, sell, or keep the property for investment purposes. It can be difficult to have these conversations, and you may want to have an advisor help facilitate the conversation, but it is very important.
“There may be assumptions, made either by a parent or by children, that aren’t accurate. And when an estate plan is created based on an incorrect set of assumptions, it can create discord among family members,” says Lyders. For example, Lyders worked with a couple who was planning to leave a vacation home to their 2 children equally so that they could continue the long tradition of family vacations. But one child lived far away and already owned a vacation home in that area. Leaving the home equally would have created issues regarding maintenance cost, taxes, and upkeep. If the siblings decided not to share the house and executed a transfer of ownership, it might have increased taxes and created transaction costs. Disagreement on whether to continue shared ownership could also have caused hurt feelings and disrupted what was otherwise a good relationship. After having a family conversation, they realized shared inheritance didn’t make sense.
“The best-case scenario is when parents make informed choices so the kids don’t have to worry or make major changes after the inheritance, and they structure the transfer to be efficient and private,” says Lyders.
How to pass the home down
There are a number of mechanisms to transfer ownership as part of an estate plan:
If you don’t take any action and die without a will or having made any other arrangements, your assets will pass according to your state intestacy laws, which may or may not reflect your wishes. This will include going through probate—a process that is potentially expensive, public, slow, and complicated. There are a number of other ways to transfer ownership that can help manage these issues.
One common idea that people have about passing the home to kids is seemingly simple: Just add the heirs as co-owners on the current deed.
If you list your child, children, or anyone else on the deed as joint tenants, they will become co-owners at the time you alter the deed and automatically take ownership of the home at the time of your death. So this approach does avoid some of the issues with probate.
There are some downsides to this approach, however. First of all, if you add children as co-owners, the portion you transferred is considered a taxable gift, so you have to report it for gift tax purposes. Say a single parent adds a child to the deed, the parent would need to report 50% of the value of the home as a taxable gift (based on the fair market value of the home at the time of the transfer). Secondly, gifts made during your lifetime are subject to carryover cost basis, meaning that, for tax purposes, your child takes on a cost basis equivalent to what yours was. Thus, the cost basis used for capital gains tax purposes doesn’t get a step-up at the time of death—instead, your child may get a larger tax bill on the portion of the house that you gave them during your lifetime, if they eventually sell the house after your death.
Finally, as co-owners, the home becomes an asset of your child, creating several potential issues. First, if your child runs into financial trouble, gets divorced, or has other issues, your home may be put under a lien or become subject to other action. Second, you would need your child’s permission to sell the home, take out a new mortgage, or refinance an existing one. And finally, your child may decide they would like to sell the home, which can create challenges. “While it seems simple, this usually is not the best solution from a planning perspective,” says Lyders.
You can use your will to pass your home on to your heirs. This process will ensure that you decide who inherits the property. However, assets that transfer through a will still pass through the probate process, which can be time-consuming and expensive. In addition, your will is a public document, so anyone can review your assets and see who inherited them. Especially in this day of electronic access, that can create a privacy concern.
A revocable trust is a legal structure that allows you (the “grantor” and “trustee”) to retain control over your assets during your lifetime, as well as specify exactly how and when your assets pass to your beneficiaries. After your death, the trust acts as a will substitute and enables the trustee to privately and quickly distribute the assets owned by the trust without going through the time and expense of the probate process. Thus, you continue to have full control and use of your home during your lifetime while providing for efficient distribution at your death.
Assets in revocable trusts can have implications for Medicaid. Due to the complexity of trusts and the variation in state-level rules, it is important to work with a professional to set up a trust, which costs money, but may be the only way to ensure that the trust works effectively. It is also important to remember that it may be necessary to change the titling of your assets for the trust to function as intended.
Finally, a trust may be particularly beneficial for families that own properties in more than one state. If you don’t establish a trust, your estate may pass through probate in multiple states.
“For many of my clients, one of their main goals is to pass down assets to beneficiaries without probate, and so a revocable trust is a core component of their estate plans,” says Lyders.
Qualified personal residence trust (QPRT)
A QPRT allows you to move a primary or vacation residence out of your estate at a reduced gift tax cost. With a QPRT, the home is transferred to the trust right away; however, you retain the right to live in the home for the duration of the trust. During that time, you are responsible for rent, maintenance, taxes, and other aspects of ownership. The trust has an end date after which ownership of the house is transferred to the beneficiary (generally children or a trust for their benefit) and the original owner no longer has the right to occupy the house (although a lease may be negotiated with the beneficiary).
In order for this strategy to be effective for tax purposes, you must outlive the term of the trust. Otherwise, if you die before the trust terminates, the value of the home is included as part of your taxable estate. While a QPRT may be used for a primary residence, it can be challenging for a person to lose the right to occupy their home, or pay rent to do so, and thus QPRTs may often be used for vacation homes.
Two big benefits of a QPRT include the reduced gift tax cost of the transfer (because you retain the right to live in the home for a period of time), and that the value of the home is frozen for estate tax purposes at the time the trust is created. This means that for estate tax purposes, the value of the home is established at the time it enters the trust—and future price appreciation won’t affect the estate’s tax bill. For a family facing estate tax issues, this strategy may help to limit taxes in the event that the property value increases over time.
Note that property that is subject to a mortgage can be difficult to handle from a gift tax perspective, and therefore it is often suggested that any debt be paid off prior to the transfer to a QPRT.
Beneficiary designation—a transfer on death (TOD) deed
Some states offer a TOD designation on a deed which essentially names a beneficiary for that property. With a TOD designation, assets pass outside probate, so it’s quick and private, and your heirs still get a step-up in basis for tax purposes. It may also be less expensive than setting up a trust.
There are some drawbacks to a TOD designation. It only allows you to name individuals or charities, so you don’t have the ability to name a trustee under a trust. That means that if your children are still young at the time of the transfer, they would directly own the home, which may not be practical. There is also no contingency, so if you outlive a child who is named as a beneficiary, there is no provision to skip a generation and pass the asset to their children—you would need to update the TOD deed. Additionally, if you pass the home to an adult receiving government benefits, it could affect their eligibility.
TOD deed options are limited by state law—many states do not offer this option at all. Check with your attorney or tax advisor to determine whether this option is available and would be appropriate for your circumstances.
If you don’t think your children will want the home, you may want to consider selling it and renting a home later in your life. Issues like maintenance, health, and lifestyle may be more important than the financial considerations here, but be sure to consider the tax impact of this decision. Current tax law allows you to exclude $500,000 of capital gains from the sale of a home, provided that you have lived there for 2 of the previous 5 years, and that the home meets the residency requirements. Gains above that amount are taxed. Inheriting a property comes with a step-up in basis, potentially eliminating capital gains tax.
The bottom line
A home can be the most valuable asset in an estate. It can also pose unique and emotional issues for a family. It’s important to come up with a plan that makes sense for you, and your heirs, and to create an efficient strategy to execute it. ◊