It is a common scenario. Your parents are retired. Perhaps their health is starting to fade a bit, and they know they have more years behind them than they have ahead of them. So they decide in order to make life easier they will transfer ownership of their home or perhaps some of their investments to one of the children.
The reasons are noble. They think this will make things easier when they pass away. They are intending to leave you the home anyway, so why not just add you as a joint owner now so you don’t have to worry about wills and probate? Simple and clean. Right?
While the intentions may be good, there are several reasons this is a very bad idea.
Changes you from an heir to an owner
There could be some pretty severe tax consequences to transferring ownership prior to death. The problem is the IRS treats an heir very differently from how it handles an owner.
When you sell an investment or a piece of real estate, you generally owe capital gains tax on the difference between what you paid for it and what you sell it for. There are lots of rules and exceptions, but generally speaking suppose you bought a house for $100,000 and then 5 years later sold it for $125,000; you would potentially owe capital gains tax on $25,ooo, your net gain on the sale.
So what does that have to do with your parents transferring assets to you? Let’s say they bought their home 40 years ago and paid $25,000 for it. Now 40 years later the home is worth $225,000. When Dad transfers ownership to you that $25,000 purchase price is also transferred to you.
What that means is that if you plan to sell the house after your parents pass away, you will owe capital gains tax on $200,000, the difference between what they paid for it 40 years ago and what you now sell it for. Under current rules, that’s about $30,000 in taxes you will owe.
Now let’s suppose Dad had a will and left the home to you as part of his estate. When you inherit the house in this way, the IRS provides you with what is known as a “stepped up basis”. In simple terms what this means is that the IRS now considers your basis for the home as its current value and not what your parents paid for it. That means from the IRS perspective your purchase price is $225,000. You sell it for $225,000. Your net gain is $0 and you owe no taxes.
By trying to be helpful and make life easier in our example, the parents created a $30,000 tax bill that was completely unnecessary. That’s a big deal.
Another problem with joint ownership of assets is liability.
Let’s say Grandpa makes his son a joint owner on the family house. Meanwhile, grandson turns 16 and gets his drivers license. He gets in an accident as 16-year-olds are liable to do, and it’s a really bad one. Someone is killed and a couple people are gravely injured resulting in several hundred thousand dollars of medical bills. Dad is sued because the insurance wasn’t enough to cover such a severe accident, and there aren’t enough funds to cover the settlement so Dad is forced into bankruptcy.
But wait a minute. In bankruptcy, you must sell what assets you have to cover as much of the debt as possible. Problem is Dad owns half of Grandpa’s house. It is possible that the court may force Grandpa to sell his house to help cover the expenses from grandson’s accident.
While these kinds of scenarios may not be common, they are possible. By making his son a joint owner, Grandpa has opened the door for the possibility of losing his home should something tragic happen.
Disinheriting other children
Here’s one more scenario. Let’s say that Mom and Dad have 3 kids: one son who lives nearby, and a couple of daughters who got married and moved away. Mom and Dad make the son a joint owner since he is close by with the understanding he’ll sell the house and split the proceeds after their death. There are several ways this can go wrong.
The worst is the son decides not to sell. Perhaps he figures he is owed something because he was close by and helped mom and dad through their failing years. Effectively the end result of this is the two daughters have been disinherited.
Or let’s say the son does sell the home, but the daughters feel he didn’t get nearly enough for it. Now there is discord in the family because the daughters feel they are getting “cheated”.
These are the kinds of circumstances that can destroy family relationships forever.
There is a third way this can go wrong. Let’s say the son does follow the parents wishes. He sells the home for a good price and everyone is happy. We already saw one way that this creates an unneeded tax bill due to not having the stepped up basis. But there is one more way the IRS can get involved. Since the son was the owner, in the eyes of the IRS, the money from the sale all belongs to him. When he tries to do his parents’ wishes and distribute the proceeds to his sisters, the IRS considers that a gift. If the amount is significant then there may be gift taxes owed on the distributions.
Had the parents simply just left the home to their children in their will, there would be no capital gains tax and no gift taxes involved.
Lessons to remember when you transfer assets.
- Unless the total value of the estate is more than several million dollars, it is almost always better to leave your assets to your heirs in your will as opposed to transferring homes or investments while you are still alive.
- You should always have a will.
- If you have any assets of significance at all, seek the advice of a good estate planning attorney. You might spend a few hundred dollars now, but you may save your heirs thousands in unnecessary taxes.
- Many of your assets can be titled in a “transfer on death” arrangement. You retain ownership during your lifetime, but the assets are transferred to designated beneficiaries upon your death, without the need of probate court involvement. Talk to your estate planning attorney about how this might apply to your situation.