Attorney Thomas B. Burton answers the following question in his Popular Real Estate Question and Answer Series: "How Can I Leave Rental Home to Daughter and Avoid Capital Gains Taxes?"
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Welcome back to Real Attorney Reacts!
I'm Attorney Thomas Burton and today, we're once again going to be looking at a question submitted to The Moneyist column on Market Watch about a rental home in California and how to leave it to a daughter, tax free and as a reminder, I look at these readers submitted questions because they're often similar to questions I see come up in my office and they're presented in a nice format and then we walk through them, walk through The Moneyist answer and then analyze how I would evaluate it, under Wisconsin law.
So let's get right into it.
The title is "I own a rental home in California. How can I leave it to my daughter, so she can avoid capital gains taxes?
"My daughter will probably keep the property as a rental but she might use it as a second home and or as a partial week to week vacation rental.
So likely Airbnb, VRBO, short-term rental something like that.
"Dear Market Watch, I live in California and own a single-family rental property that has a tenant with a 12-month renewable lease. The home is in a revocable trust", so right away I think, 'very good, she does have a plan for the home' and if you've ever listened to Suze Orman, on PBS, she has a story about her mother who owned a small home in California but due to the probate laws in California and the high fees and expenses, she spent, I think she said something like $10,000 to get the home transferred upon her mother's death and that's why she recommends everyone with a home, have a revocable living trust and California, from what I know, has very high probate fees and expenses and attorney’s fees.
Okay, so this lady goes on, "I would like to leave the property to my daughter. I have one other child who I don't intend to leave any of this property to. My daughter will probably keep the property as a rental but she might use it as a second home and or as a partial week to week vacation rental. How do I structure my will to leave the property to her, so she can avoid probate and paying capital gains taxes" - Sincerely LA Landlady.
First thing I notice here is she's asking The Moneyist how to structure her will but earlier she said she has a revocable trust. So I'm a little concerned for this lady because I feel she maybe doesn't understand her estate plan because generally, if you have a revocable trust, that's better than a will, so she should be looking at how to structure the trust because why would you want to take a house that's in the trust, passing outside of probate and try to bring it back into your will which would go through probate court and be very expensive in California. So I think she really meant to say "How do I structure my estate plan or trust to avoid paying capital gains taxes" but again, my initial reaction is she has a trust and I would want to look at that because that is probably the best way to leave it to her daughter.
Let's see what The Moneyist says, "Dear landlady, since starting this column about a year ago, one of the most common questions I get is about the best way to leave a home to one's children. Parents recognize that real estate is a useful avenue toward building generational wealth. They want to ensure their children get the most out of their inheritance. It makes sense that you want to avoid probate. In many states, it's a costly process and the fees involved can eat into the value of the state." So that's in my opinion, the understatement of the year, especially because he's dealing with California here and I don't know if he knows that but historically, across the country, California is one of the most expensive probate states for fees, expenses and lawyer fees.
He says, "Your situation is a little more complex though because the property isn't your primary residence but a rental home, so there are different considerations involved" and he is right that this is slightly different than your home, I always generally, if you can leave your home through a revocable living trust, it's often the best plan and you occupy it but he is right to point out here that with rental property, there's a few other things to think about. So he says, "I pulled financial advisors to get different strategies that address your concerns. The first and potentially easiest option presented to me by David Buys, a financial planner in Texas is to convert the property's deed into revocable transfer and death deed. This option is available in California in 2016 and available in 25 other states". So I'm not sure why he's polling financial advisors because to me this seems like a legal question. I would prefer he was polling lawyers licensed in California and this guy's in Texas. So he's right, you could use a transfer on death deed but why would this lady use a transfer on death deed when she's already put the money in place to put a trust together.
He's saying, "this type of deed would allow you to avoid probate unlike a joint deed, adding her to the deed as your designated grantee, isn't a taxable event in the eyes of the IRS". He's right about that. "There are some drawbacks though, for instance, if you were to become incapacitated due to an accident or a health event such as a heart attack, your daughter may not be able to revoke the deed herself. That could complicate matters because doing so, might be necessary to qualify you for Medicaid". So he's exactly right there. This type of deed, doesn't protect you for incapacity planning or Medicaid planning and so, that's why these transfer on death deeds are not the end-all be-all because they don't provide that incapacity protection of a trust. What happens if you're still alive but you're incapacitated? So again, this lady said she has a trust. I don't think, if I were her and I already have a trust, excuse me, I would take it out of the trust, to go use a lesser form of planning.
Now he says, "Putting a home into a trust that you have already done is another common strategy that people use to bypass probate and one that was recommended to me by many financial advisors". Okay hurray hurrah, good to hear some people mention the trust because as we see in the fact she already has it but then this guy says, "But there are potential pitfalls namely in the form of capital gains taxes. After you die, your daughter may wish to sell the property rather than hold on to it".
"If she were to inherit it through your will and probate, then she would be entitled to step up in basis. What that means is that instead of the original price you paid to purchase the rental home, the home's value at the time of your death would be used to calculate the cost basis plus any expenses tied to improvements or maintenance".
He's right about the Step Up in Basis, under current law, that's why you want to leave property at death, so the heirs can get what's called new basis at death instead of taking the parents old basis often whatever they paid for the property. If the property is appreciated significantly in value over the years that could represent a major difference and without the step-up in basis, she could be on the hook for taxes on hundreds of thousands of dollars in profit and that's true because she would owe capital gains tax on the gain.
"The form the trust takes is critical here. Assets that bypass the estate through a trust or another mechanism, are not, usually not eligible for step up in basis. Kristin McKenna, Managing Director at Darrow Wealth Management wrote in a blog post. However, a home held in a revocable living trust, likely would be eligible for the step up in basis". So I agree there, I, homes in trust are eligible for the step up in basis. So I don't know where they're getting that. If they're thinking she created some type of irrevocable trust but I can even create an irrevocable trust that qualifies for it with the right type of planning inside the trust. So I would tell this lady, talk with your lawyer and make sure your revocable trust is the type that gets step up in basis for the daughter and my guess is, it would have been drafted that way if this lady told her lawyer, why she's putting the real estate in there for the daughter but they went through this whole long paragraph about "Oh maybe it won't work with the trust but then at the end, he said "However a home in a revocable living trust likely would be eligible for the step up in basis" and I think that's the takeaway.
So for this nice lady, if you're listening, I would sit down with your lawyer because you can see these financial advisors kind of give a little bit, it's like the blog post says, it might not but then it might, so you want to really have an attorney look at the terms of your trust because under current law, that step up in basis still works and it would be important to get that through your trust and the vast majority of trust, I draft that's why we're doing it, to get that new basis at death, leave the asset at death, it doesn't matter if you do it through the will or the trust.
"One final strategy multiple advisors recommended was to put the home into a limited liability company or LLC. This route would have benefits to you in your lifetime too because it protects your personal assets from liability or any financial or other problems to arise in conjunction with the rental home. Plus, LLCs can attract better tax treatment in some cases. You could then place the LLC into revocable living trust or simply create a clause in the top-ranking agreement that stipulates succession to your daughter in the event of your death".
I like this idea because she is operating it as a rental property. She could put it inside an LLC and then the trust could own the LLC and we can do that simply, I love using LLCs with trust because you can simply assign your membership interest in Wisconsin to the trust and you don't have to do any other complicated paperwork and then upon her death, let's say the LLC was named Southern California Rental Property LLC, she could just leave the LLC to her daughter instead of the deed or the title directly and it would already be in the LLC and the daughter could have the LLC and keep operating it as a rental.
That's a very good option, if your plan is to keep operating it as a rental. Now I do know in California, the fees, the ongoing annual fees for an LLC are quite a bit of money. A couple of hundred dollars a year and that may be why this lady didn't do it that way but it depends on her income from the property because it would be an expense of the business, if it's worth it to her. Now here in Wisconsin, it's a very reasonable $25 annual filing fee to keep your LLC current. So I don't see that as a big burden for the benefits you get from it in terms of asset protection.
"There might be some complications, if there's a mortgage on the rental property. So that needs to be considered" - Warren George Gagliardi, founder of Coromandel Wealth Management.
"Before you get to work on this plan, it might be worthwhile to nail down exactly what your daughter wishes to do with the property when you die and this is a California wrinkle proposition 19 which was passed in California in 2020, has some very serious ramifications for people who inherit valuable investment properties. If your children decide to rent your home after inheriting it, they will pay property taxes based on the market value when inherited - Chris Deckard, Lead Advisor and Partner at Wealth Management Firm Financial Alternatives, wrote in a blog post. Families had, until mid-February of this year to transfer property to their children retain the original property tax rate".
So that's a California specific wrinkle, not, wouldn't apply here in Wisconsin.
The Moneyist concludes by saying, "It appears her best option is to sell the home, then she would opt for whatever strategy ensures, if it appears, this is for the daughter her best option is to sell the home. Then she should opt for whatever strategy ensures she will pay the least amount in capital gains taxes, given the nuance here I would suggest consulting with an attorney, well versed in a state law to clarify the terms of the trust the home is already held in and what the tax implications are".
So there, that is what this lady should do and if the attorney who drafted your trust is still in practice, I would just go back to them because they can likely put the trust and very quickly tell you, answer those key questions about the tax status and then they could also, if you want to think about throwing it in an LLC, they could likely help you with that as well.
Overall, the columnist, I feel gave her some good options here for the house but the main takeaway for me is she did a great thing by putting this property into a revocable living trust and I don't see a big compelling reason to change that plan unless she wants to add, the added asset protection of an LLC by putting the rental property inside of the LLC and then assigning the LLC to the trust. But from what I see here in Wisconsin, this would be a very good plan and a way to ensure the property passes to the daughter without probate upon death and gets the step up in basis, for capital gains tax upon her death as well.
So this again I thought, a very interesting question for the other viewers out there. Hope this has been helpful to you as you consider your own mix of assets and estate planning and if it has been helpful to you, please consider giving it a LIKE so that others can see and benefit from this information as well.
Thanks for watching and we'll see you next time.
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