This is a guest post by by Alan D. Khalfin, an estate planning attorney at Vaksman Law Offices.
One of the most common questions that I get from clients is “How should I take title to my new home?” The answer deserves careful consideration, as this is one of the most important decisions that you will need to make when purchasing a new home.
Why Is Titling Property Correctly So Important to Homeowners?
First, if titled incorrectly, the property owner cannot control what happens to the property after he dies. Second, if titled incorrectly, the heirs can lose the property to creditors, the government, or even an ex-spouse. Finally, if titled incorrectly, the heirs will have to pay capital gain on the sale of the property.
Three Common Ways to Hold Title
Joint Tenancy: The worst part about joint tenancy is the owner who dies first cannot control what happens to the property after his or death; rather this will be decided entirely by the surviving tenant. Joint tenancy also ensures that there will be a probate upon the death of the second joint tenant. Moreover, the surviving joint tenant will pay capital gain taxes on one-half of the property after the death of one joint tenant; only the interest passed from the deceased owner gets a step-up (or step-down) in basis, and if the asset is then sold, the survivor may have to pay substantial capital gains tax on the appreciation on his portion of the asset. Finally, the property is exposed to the creditors of all joint tenants, so if one of the tenants has creditors, files for bankruptcy, or is sued, then the full value of the property could be subject to sale or collection.
Community Property: Possibly the most common way for married couples to own property, Community Property causes half of the property owned as community property to be probated upon the first death and the whole property must be probated upon the second death. Probate is very time consuming and costly, and should be avoided at all costs!
Community Property with Right of Survivorship: Like joint tenancy, CPw/ROS is a he who dies last wins situation, because the surviving owner controls the disposition of the property on her death. While CPw/ROS does avoid probate and can provide a step-up in basis, property passed to the surviving spouse will be subject to certain creditor's claims of the deceased spouse. More importantly, the whole property must be probated upon the death of the surviving spouse.
The Fourth and Best Way to Own Property: A Revocable Living Trust
A properly drafted and funded living trust will avoid time consuming, expensive and public probate upon the first death and the second death. A living trust will make sure that the right people receive the property after the death of both owners and that it doesn’t go to creditors, predators, or future spouses. Moreover, if an asset is inherited through a living trust, the new owner receives a 100% step-up (or step-down) in basis, and if the new owners sell the asset at that time, they can avoid or reduce capital gains tax on the appreciation (i.e. the difference in value from the new basis and the actual value at the date of sale). Finally, married property owners can combine their respective Federal Estate Tax Exemptions to maximize the amount of wealth that is transferred to heirs estate tax free.
An Example: Stepped-Up Basis
After explaining the above to clients, everything tends to be clear, except for how the step-up in basis actually works. Here’s an example:
Joint Tenancy: Let's say David bought his Burlingame home in 1995 for $500,000 and today it's worth $1,000,000. He gives it to his wife, Kate, by making her a joint tenant, and Kate then sells the property for $1,000,000 after David dies. Because David transferred title to Kate while he was living (by making her a joint tenant), the house keeps David’s old cost basis of $500,000 (what he paid for it). Kate now has a $500,000 gain on the sale and will have to pay significant capital gains tax.
Revocable Living Trust: If David had left his home to Kate through a living trust, and Kate then sold the house for the same $1,000,000, there would be no capital gains taxes to pay. Because Kate received the house as an inheritance through David’s living trust (instead of as a gift while Kate was living), the property receives a new stepped-up basis. The basis is now the value as of the date of David’s death ($1,000,000), so when Kate sells the house, there is no gain on the sale and no capital gains tax to pay. Moreover, by having the property owned by a living trust, David can make sure that the right people receive the property after the death of both owners and that it doesn’t go to creditors, predators, or future spouses.
Community Property with Right of Survivorship: If David gave the property to Kate through CPw/ROS, then the property would receive a new stepped-up basis after David’s death. However, after David’s death, Kate would solely control the disposition of the entire property on her death, which may not have been what David intended (especially if David has kids from a previous marriage and desires that these kids receive a portion of the property upon Kate’s death). Moreover, the whole property must be probated upon the second death, and could end up in the hands of creditors, predators, or future spouses. To avoid these pitfalls, David should make sure that title to the property is in a revocable living trust.
This article is intended to provide general information and should not be relied upon as legal advice. You should consult with an attorney about your particular circumstances before taking any action.
About the Author
Alan D. Khalfin, Esq. provides holistic and personalized estate planning to clients, including all aspects of wealth transfer planning, sophisticated tax planning, asset protection, and business planning strategies.