In the first part of this series, I talked a bit about the planning you can do for inheriting property involving Living Trusts and Wills. Now, we’re going to shift to everyone’s favorites subject – TAXES!
#1 Caveat – I am NOT a tax professional. This article was written to provoke you to action. Go see a tax professional to help you figure out the best way to take care of yours or your parents estate. A little cost for good advice could save you some substantial sums later on when the IRS comes knocking.
I had the benefit of speaking to Paul Johnson, my CPA, recently and he got pretty fired up about the mistakes that people make and what NOT to do so please take note. This isn’t an all inclusive list as this is a very BIG subject with many variations on a theme.
Paul’s caveat to me is that this applies to California and property in California because he lamented, all states have their own way of taxing inherited property.
Did you know that California is one of only 9 states that is a community property state? I was shocked to recognize there were so few! Here they are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. I don’t know why but Wisconsin seems like an outlier in the list. The lineage of community property laws seems to have some origination in Roman-civil law, then Spanish law, which finally migrated to Mexico and then was inherited by much of the Western United States (and Wisconsin!) Hey my mom’s from Wisconsin – Beer, Cheese, and the Packers, right? I digress. So anyway, Community property laws matter because when two people are married, property transfers relatively easily to the surviving spouse.
Okay, but let’s say that the inheritance is going to the children. Here’s 3 common mistakes that can cost you:
Mistake #1: Fair Market Value (FMV) at Date of Death
Not getting a Fair Market Value (FMV) (such as with an appraisal) established at Date of Death.
Lucy’s parents purchased a home for $50k a long time ago. The home is now worth $500k. Lucy’s father passed away about 15 years ago and her mother, who stayed in the home, just passed away about a month ago.
What they should do: Get an appraisal or a Fair Market Value (FMV) established as soon as possible.
Why?: This represents the new tax basis to determine capital gains.
General Mistake and why it matters: Say that this is in a living trust, the children inherit the home from the remaining parent who passes away but they don’t get an appraisal or determine FMV at the date of death and they choose to rent it out or sit on it for a year.
If they choose to rent the property they will need to know the basis in order to take advantage of the additional depreciation they would get on their tax returns. If they sit on the property and later sell it, it will be more difficult for them to establish the tax basis of the home one or more years later…an uninformed tax person could have them pay taxes on $450k of gain. Getting a good appraisal on the home will provide proof to the tax authorities of any capital gain or any capital loss incurred.
Mistake #2 – Putting an adult child on Title
Joe has been divorced for years. He purchased his home for $50k and now it’s worth $500k. He’s got one son, Todd, who lives nearby with his family. Joe thinking that he wants to make sure his son gets his home and goes and puts his son on the Title.
What they should do: Get a Living Trust and put the property in the trust naming the son as the Trustee and Heir of the property. Also, get an appraisal of FMV at the date of Joe’s death.
Why?: Non-spouses are not treated the same under the tax law.
General Mistake and why it matters: With the right of survivorship, Todd is entitled to 50% of the property, because this is considered a gift and his tax basis would be $25k on his share (1/2 of original purchase price). So, at dads death his “inherited” tax basis is just $275k, instead of $500k, because of the mistaken transfer and only getting a “stepped up basis” on ½ of the home. Thus, his capital gains would be $225k and there is no personal residence exemption because he did not live in the home.
Mistake #3 Not recording the property in the name of the Trust
Ann’s son helped his mom get a Living Trust referring her to LegalZoom.com an online option that allowed her to save some money. The problem was that Ann never actually got around to putting her home in the name of the trust. She passed away recently and the son finds out that the property is going to go through Probate rather than passing directly to him as the Living Trust dictated.
What they should have done: Get the property recorded in the name of the trust!
Why? Successor Trustees can sell the property on behalf of the deceased without going through Probate.
General Mistake and why it matters: The Living Trust is the legal “directive” so to speak, but each asset must change ownership to the name of the trust in order for the Trust to pass the assets to the beneficiaries without passing through Probate. If they don’t get it recorded in the name of the Trust before the person passes away, they can talk with a Trust Attorney to see if the property might qualify for the Heggstad Petition. (This last bit was given to me by my awesome Title Rep!) Otherwise, the title company will inform the son that the home must go through probate because it is not titled in the name of the trust. Probate means one must go to court and the court approves the sale and the distributions and expenses of sale. The cost of going to court, hiring an attorney, getting appraisals and paying court fees will probably cost at a minimum $2,500 to $5,000 when this could all have been avoided by properly transferring title on the home to the trust.
If you take nothing else from this blogpost, do two things: Seek a Tax or Trust professional’s help before you need it and remember to get a Fair Market Value established on property when someone passes away. Attorneys and tax professional can sometimes work around bad decisions but it usually costs less to get their help beforehand.