y couple with modest assets may take seemingly minor steps that have devastating tax consequences.One of the most common of these mistakes is adding their children to the title of their house. Often, they do this without the benefit of advice from a legal professional because they want to avoid spending a few hundred, or even one or two thousand dollars on professional advice. What they do not realize, however, is that the result of these actions often cost their children tens of thousands of dollars in taxes once the parents are gone!
An All Too Familiar Situation . . .
In a recent case, we encountered a family where the parents owned their home free and clear and had lived in the home for more than fifty years. It was their son's childhood home and it stayed in the family until the parents passed away. When the father became ill in 2009, the parents decided to add their son to the house title so that he could avoid probate once they both were gone. They read about this on the Internet but failed to run it by a lawyer. They filed a do-it-yourself Quit Claim Deed and added their son to the title of their house in 2009.
(By the way, a Quit Claim Deed almost always is a bad idea, except perhaps in a divorce situation. Most do-it-yourself legal form books and internet do-it-yourself legal sites tout the use generic Quit Claim Deeds. Don't be fooled. Use a Warranty Deed instead.)
Whether a Quit Claim or Warranty Deed was used, the tax problem came into play when the parents added their son to the house title. Typically there are no state or local transfer taxes due when adding a child to a house title. Property transfer taxes, however, are minor compared to Capital Gains Taxes implications.
Capital Gains Taxes--the Middle-Class Estate Tax
Generally speaking, Capital Gains Taxes are assessed when people sell real estate for more than what they paid. Capital Gains Taxes are reported on the income tax return. If they owned the real estate for more than one year, the tax rate assessed will be the Long Term Capital Gains Tax Rate.
Many people know of the Personal Residence Home Sale Exclusion: if a couple sells their primary residence generally they can exempt the first $500,000 of the capital gains from the Capital Gains Tax. There are some detailed provisions, but this is the general rule. This is one way to reduce Capital Gains Taxes.
The other way to completely eliminate Capital Gains Taxes is to die owning the property in your own name. In other words, the Internal Revenue Code provides that if you own property in your sole name, then upon your death, the property gets a Step-Up in Basis to the date-of-death value. Thus, if you paid $50,000 for a house in 1940 and it was worth $500,000 when you die, your family will receive the house with a basis of $500,000. If they then sell it for $500,000, they have no gain and no Capital Gains Taxes to pay.
The Devastating Tax Burden
Back to our misguided family: the parents bought their home in 1959 for $30,000. They raised their family in the house and they both lived out their lives in the house. The father became ill in 2009 and they added their son to the title of the house using a Quit Claim Deed based on something they read on the internet. This action caused their son to get a Carry-Over Basis in the house value, meaning that his basis was the same as his parents--$30,000. Tragically, the parents passed away at the same time in an automobile accident in 2014 and the house passed to the son as the surviving owner listed in the Deed. The house was appraised as of their date of death at $600,000.
When the son sold the house for $600,000, he was assessed Capital Gains Tax on $550,000--the difference between the sales price and the Basis (plus the cost of selling the house, which totaled $20,000). The son had never lived in the house so he was not eligible for the primary residence exclusion from the tax. The Capital Gains Tax rate is 15% - 20% depending on the taxpayer's tax bracket. Fortunately the son was in a lower tax bracket so his Capital Gains Tax Rate was only 15%.
That was no consolation to the son, however, because 15% of $550,000 is $82,500! By filing a Quit Claim Deed in 2009 with no legal guidance, the couple saddled their son with a tax bill of $82,500 in 2014! Instead of leaving their son with the full value of the modest wealth that they had built up over their lifetimes, their actions eroded a large part of their estates.
Not All Advice is Good Advice
Instead of filing a do-it-yourself Quit Claim Deed, had the couple made an appointment for a free consultation with an estate planning attorney, they could have saved their son more than $80,000 in taxes. Paying an attorney $2,500 or so for a solid estate plan would have saved their son tens of thousands of dollars! If the house had passed to their son through their estates based on their Wills, the son would have received a step-up in basis on the house and he would have had zero in Capital Gains Tax due.
Not all advice is good advice in all situations. It takes a qualified professional to understand the advice in the context of a larger picture and a specific family situation. Using Quit Claim Deeds in estate planning almost always is a huge mistake, often with extremely expensive consequences.
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