In the realm of estate planning, it’s not uncommon for parents to contemplate giving their homes to their adult children during life. There would be no need for probate, the parents can still live in the house, and there may even be some Medicaid planning accomplished. But this seemingly straightforward strategy can lead to significant legal and financial complications.
Before making any drastic changes in ownership, it is important to consider the potential for adverse and unintended consequences. Let’s discuss four of the most common problems that can arise from giving real estate to your adult children.
No Step-Up in Tax Basis
One of the primary drawbacks of deeding a house to your adult children deals with the cost basis that the recipient will take. When a person inherits property from a decedent, the beneficiary receives a “step-up in basis.”
This means that for tax purposes, the property’s value is adjusted to its current fair market value upon inheritance. This step-up can significantly reduce any applicable capital gains taxes when the property is sold.
But if parents deed their house to their children while they are still alive, there is no step-up in basis. The children inherit the property with the same cost basis that the parents had at the time of transfer.
Consider the following hypothetical of how this plays out in the real world.
Parents A and B purchased a house for $200,000 in 1990. That is their tax basis. Because of appreciation, the fair market value is now $450,000. If A and B deed their house to Child C during life, C will receive a tax basis of $200,000. If C sells the house for its fair market value of $450,000, he will have $250,000 of capital gain that would likely be taxable.
Now let’s say Parents A and B pass their house to Child C after they pass away. Though A and B bought the house for $200,000 in 1990, C now has a step-up to the value at the time A and B passed away. This means his tax basis is now $450,000. He could sell the house for $450,000 and would have no taxable gain as a result.
Potential for Gift Taxes After Giving Your House to Adult Children
Beyond the cost basis issue, the act of deeding property can trigger gift taxes for parents. The IRS sets an annual exclusion for gifts. This exclusion is $17,000 in 2023 and $18,000 in 2024. Any gifts exceeding this amount to an individual can result in tax liability for the donor. Gift and estate tax rates mirror each other, and they approach 40% fairly quickly.
Let’s use our previous hypothetical’s numbers. If Parents A and B give the house to Child C, that constitutes a $450,000 lifetime gift. Each has an exclusion of $17,000 per person in 2023, $34,000 total for this married couple. That makes $416,000 of the gift taxable.
Based on the gift tax rates for 2023, that would place the value of this 2023 gift in the 34% bracket. That gift tax is what the parents would have to pay to the IRS.
To avoid this, the donor must file Form 709 with the IRS for the tax year in which that large gift happened. The donor uses a portion of his or her gift and estate tax exemption credit to avoid tax liability. The tradeoff is that this reduces what the donor can pass down tax-free after death.
Liability Exposure: Risks of Judgment Creditors
Transferring a house to adult children during life exposes parents to potential liability arising from their children’s actions. If adult children face legal claims or judgments, creditors may target the parents’ home if it is in their adult children’s names.
Even though the parents may still live in the house, the house is legally the adult child’s property. This means creditors can reach the house as an asset to satisfy debts, potentially leaving the parents homeless if they are able to seize it.
Consider a scenario where Child C now owns Parents A and B’s home. Child C drives under the influence of alcohol and gets into a collision that severely injures several people. Those victims sue C and obtain a judgment of $1 million.
Unless C has enough insurance coverage, assuming the carrier would cover this situation, the excess of the coverage could be satisfied by placing a lien on the house and potentially foreclosing.
If Parents A and B kept the house, C’s actions will have no bearing on their ability to keep it.
Medicaid Planning: The 5-Year Lookback Period
For those considering Medicaid planning, deeding a house to adult children may seem like a quick and easy way to qualify. But Medicaid eligibility is subject to strict rules.
Medicaid has a lookback period of five years to determine if a prospective recipient has made transfers of assets to make him or herself appear qualified for state aid. If there are ineligible transfers during the lookback period, this will cause issues for the applicants. If ineligible transfers were made, there is a blackout period before state benefits will commence.
Transferring a house to adult children within this timeframe would likely jeopardize Medicaid eligibility, impacting long-term care plans.
Final Thoughts on Giving Your House to Adult Children During Life
While the idea of giving your house to adult children may seem like a straightforward estate planning strategy, the pitfalls highlight the need for careful consideration and professional guidance.
Before making such a decision, it’s crucial for parents to consult with legal and financial professionals to ensure they fully understand the ramifications, and explore alternative strategies that align with their long-term goals.
To discuss your estate planning needs, reach out to Connell Law, PLLC today for your free consultation. Plan today for a more peaceful tomorrow.
