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Should Parents Give Their Home To Their Children?
This is a frequent question that we receive from our clients. Initially, this might seem like a good idea. Parents, either because they want to help their children out, or, in an attempt to reduce the taxable value of their estate upon death, decide to transfer ownership of their home to their children. While this might seem to be beneficial at first glance, it might not always work out that way.
Parents often don’t realize the security of home ownership they are giving up especially if they plan to continue living in the home. If your children were to get divorced, the soon to be ex-spouse could have a legitimate claim on the home. Creditors can seek to place a lien on and foreclose on the home if your children default on a loan or suffer a loss in a legal dispute. Your children might even sell the property without your permission.
However, there are cases where a transfer does make sense. The following will discuss some general considerations and, if a transfer is advisable, provide general guidance on some of the available options to transfer your home.
Qualifying for Medicaid
Many parents think transferring a home to their children will help them qualify for Medicaid’s long term care benefits. But in many cases, that is not true. When an applicant gives away property within five (5) years of applying for Medicaid coverage benefits, Medicaid presumes that the gift was made in order to qualify for Medicaid. This will trigger a period of ineligibility on the theory that the property could have been used to pay for the individual’s care.
In reality, the house may not have been counted in the Medicaid asset valuation determination in the first place. For example, the five-year rule is not applicable if the applicant is transferring the property to his or her spouse or to a child who has been living in the house and providing the applicant necessary nursing care type services for at least two years.
A home transfer is generally not advisable as a wealth preservation or tax minimization strategy if the value of the parents’ estate is anticipated to be within the amount allowed for exclusion under Federal and State tax law. The overall amount of tax due is likely to be less if the home changes hands as part of a normal inheritance process. The heirs will receive a step-up in the cost basis and will be able to sell immediately with no or minimal impact on income or capital gains tax.
Parents wanting to sell and/or downsize can sell and share the proceeds of the sale with their children and, depending on the amount to be shared, gift taxes can be avoided as well if proper planning is done. In addition, for a married couple, the first $500,000 in profit is free of capital gains taxes, or the first $250,000 for a single taxpayer, provided certain conditions are met.
Transferring a home also removes the option of taking advantage of a reverse mortgage in the future. A reverse mortgage is a tool that allows homeowners to borrow against a home’s equity and continue to live in the house with the understanding that the loan, and accumulated interest, will be paid off, generally in a lump sum, when the house is sold, the borrowers move out, or upon the death of the borrowers.
Large Estates and the Use of Trusts
In cases where transferring ownership would reduce the parental estate to a level where no Federal and State estate tax is due, a transfer can be a good idea if it is structured properly. It might be the best way to preserve the highest value of assets for the children, even if the children later decide to sell and owe taxes on the proceeds of the sale.
If the parents want to transfer ownership, one option is to set up a “life estate” in which the parent would pay “fair market” rent to the child. If rent is not paid, the parents will be considered to have a “retained interest” in the house, in which case the IRS and State authorities could treat the transfer as if it never occurred and decide that the house is includable in the parent’s estate for tax purposes.
Another option, a Qualified Personal Residence Trust, allows parents to transfer their residence to their children, through the Trust, with the potential for substantially reduced estate and gift taxes. It also allows the parents to stay in the home for a predetermined period of time which they select themselves. In this type of arrangement, if the parents live on the premises, it can greatly reduce the gift tax which is imposed at the time of the transfer. Depending on how long the parents plan to stay, the taxable value of the gift can be as little as 25% of the current fair-market value of the home. All appreciation in the value of the home after the initial transfer also becomes tax free for both the Trust and the children.
Parents with large estates also might consider gifting or selling their home to a Defective Grantor Trust. The parent freezes the value of the home for transfer tax purposes at its current value, and any further appreciation during the parent’s life happens outside of their estate. Any income earned by the Trust is taxable to the parent. But by gifting or selling the property to the Trust, the parent reduces the value of his or her estate immediately, and all appreciation in the property will be tax free for the children.
It is highly advisable to obtain legal and accounting counsel prior to making the decision to transfer your home, or any other real property for that matter, to your children or other parties. This can help you to avoid many tax liability traps and insure that the transfer is accomplished in the most tax efficient and legally binding manner possible.