FYI: Unsure of where to begin? Read our updated guide to estate planning.
As we age, a home represents more than a sentimental piece of family history; it’s potentially our most valuable financial asset. More than 70 percent of older adults report that their homes are their most important investment.
When creating an estate plan, it’s essential to consider how to pass down your home. When done properly, you can help your loved ones build generational wealth. However, failing to consider tax implications can leave them with a heavy burden.
When passing down a home to a loved one, here’s what you need to consider.
FYI: Unsure of where to begin? Read our updated guide to estate planning.
When planning to pass down your home, you’ll need to consider both your own financial picture as well as that of your heir(s).
If you sell an investment — in this case, a home with equity — you have to pay a tax on how much the value of your investment increased. This is appropriately called the capital gains tax. For example, if you bought a home for $100,000 and later sold it for $300,000, you would then be liable for taxes on the $200,000 profit.
Capital gains taxes can still apply to property that’s passed down to children. If you were to pass down a home you bought for $100,000, and your child then sells it for $300,000, they’d still be liable for taxes on the $200,000, even though they weren’t the initial purchaser.
Depending on your location, there are some exemptions to this type of capital gains taxation.
For example, the taxable gain would be different if your children inherited the home after you passed and lived in it for at least two years before selling it themselves.
Since the goal of issuing an inheritance is to provide for your children and not saddle them with debt, reducing capital gains taxes is an important topic to bring up with your estate planner.
If you’re looking to draft an estate plan with affordability in mind, you should check out Retirable, a virtual estate planning platform.
Nearly a third of senior homeowners owe money on their mortgage, home equity credit, or both, according to the National Council on Aging. Gifting your home to your child while you still have outstanding debts on your mortgage or line of credit can result in one of two possibilities, depending on the type of mortgage.
If the mortgage is transferable, your child will become responsible for paying it off. If it’s nontransferable, they’ll have to refinance the debt, which is a costly and occasionally unmanageable process.
Reducing or eliminating mortgage and credit debts even after you retire can help to ensure that your heirs don’t inherit your payments.
You could consider giving your house to your children even if it’s still your primary place of residence. That would make you their tenant, which changes how estate taxes work, since you won’t be the property owner when you die.
Similarly, you could put the house in a trust while still living there, effectively cutting off the home’s value appreciation for tax purposes. This could help you stay below the value threshold at which your home qualifies for estate taxes.
Note that states have different limits for when a home qualifies for estate taxes, so speak with your estate planner about whether or not this applies to you.
Since your home is likely your largest financial asset, you might still need to cash in on your equity or use it to leverage a loan while you’re still alive. You could be one accident away from needing your home to pay for necessary expenses.
If you pass your home to your heirs prematurely, you could cut yourself off from this valuable source of financial security. In light of the growing costs of long-term care (Genworth puts the national monthly average at $9,034 for 2021), you might not make it on Social Security alone.
Since 70 percent of seniors require long-term care at some point in their lives, this should be an important consideration in your estate planning.
Pro Tip: Unfortunately, Medicare doesn’t cover long-term care. To learn about a variety of ways to pay for these costs, read our guide: How to Pay for Long-Term Care.
In addition to those practical considerations, you’ll have to decide how to pass your home down to your children in a way that’s financially and legally sound. There are four primary ways to do so.
If you add your child’s name to the deed of your home, they’ll legally become a co-owner. The reason you might use this method is to avoid inheritance taxes, since they’ll already be in possession of the house while you’re alive.
Co-ownership is not always straightforward. The estate’s value divided by two has to be reported on your child’s tax returns as a gift, which can be costly when calculating capital gains taxes. They’ll be responsible for taxes on the house’s unrealized gains when they finally sell it. Additionally, as a co-owner, they may want to sell the home while you’re still alive (or refuse to), which can complicate things.
This method is a good fit for someone who lives in a state with a death tax and can work on a plan with their family to make the best use of their home equity and reduce their capital gains taxes. Those with more complex family situations should avoid adding their kids to the deed.
Selling the house to your children could work, so long as you price the house at a fair market value. Otherwise, the house will be taxed as a gift, which can be costly.
If the child can afford the house at a fair value, this method can be a great way for the parent to downsize in their late retirement, using the cash from the sale to fund their move while bequeathing the house to their kids.
This method won’t work as well for the parents of kids who can’t afford the house. Though you could loan them the money, you’re legally obligated to charge interest on the loan, which has its own tax implications.
If the house is in a trust, you can transfer ownership to your kids while still living there. The types of trusts to consider if you find yourself in this situation are qualified personal residence trusts (QPRTs) and revocable trusts. QPRTs generally can’t be changed once enacted, but unlike revocable trusts, the recipient is still liable for the credit on the property.
Trusts dictate how long the arrangement will last, including how long you can live in the home without paying rent. If you’re still alive and living in the home once the trust’s terms expire, you have to start paying.
A trust could work if a family is on the same page in terms of living with each other. But if you plan on living in the home after selling it, keep in mind that your kids would have the legal right to evict you, since they own it.
A transfer on death (TOD) deed is an arrangement wherein you can name the beneficiaries of your assets when you pass. This allows your estate to avoid probate, or the process of officially proving a will, ensuring that your property transfers to the people you intend it to, even if there’s an issue with the will.
The downside is that, with insufficient assets to pay the estate’s debts, creditors can seize the TOD account among other non-probate assets. When placed in a will, these assets are protected.
However, you may still want to use a TOD designation as a simple, low-cost way to transfer assets to your named beneficiary while avoiding the probate process. Speak with an estate planner about the pros and cons of doing so, and about other transfer methods as they relate to your situation.
Estate planning, like every aspect of retirement, requires careful consideration from financial, logistical, and even emotional angles. How you pass your house down to your children can impact their future, as well as the future of their children.
Consider consulting an estate planning lawyer to help you take care of this significant aspect of your retirement. Since you worked so hard to own and pay off your house, you shouldn’t leave this one to chance.