Our parents often have no idea how to divide up their real estate. In many cases they will let their their children decide amongst themselves after they are gone. This is a recipe for disaster. Most likely, not every child will have the same interest in keeping the property. One might want to sell it; one might want to keep it but has no interest in helping to pay its ongoing costs. And of course all the grandchildren want to keep the property since it often has been such a place of joy for them.
How are you to advise your parents to plan for the disposition of their property in a way that you and your siblings have a say in it? You, your siblings, and your parents must discuss with professional advisers all the options available to them in transferring the value of their real estate.
Let’s look at various options and see how they might work.
Gifting Real Estate Before Death
What if your parents want to give their home to one of their children now rather than wait until they have passed away? One of my clients came to me and said that his mother wanted to transfer her real estate to him. She wanted to do this to get it out of her estate and protect it from the government if she should need nursing home care. She still intended to live in the house for the rest of her life.
I told him why I thought this was a bad idea. First of all, if she gave him the home, she would transfer the cost basis to him.. She and his father had bought the home for $37,000 in 1955. It was recently appraised for $550,000. All the gain in the house would be taxable when her son sold the house in the future. If she had passed the house to him after her death, all the gain would have been forgiven for tax purposes. This forgiveness of gain is called “step up in basis” and would apply to any capital property like stocks and real estate.
In addition, the house was now a potential target for the son’s creditors. That might not concern him but it should concern his mother. If he should ever have credit problems, the creditors could attach their loans to the house and potentially drive her out and sell the house right out from under her. Also, if her son had marital problems and got divorced, his ex-wife could claim the house as one of the assets in the divorce settlement. All in all, the direct gift of a parent’s home to you is not a good idea.
Gift a future interest in the house to a child
A better approach would have been for my client’s mother to retain a life interest in her home and gift the remainder or future interest in the house to her son. This is called a life estate. Two entities, the “life tenant” and the “remainderman,” hold title to the property. The life tenant has the right to use the property for life and the remainderman obtains the ownership of the property at the death of the life tenant. The life tenant pays the cost of the property while she is alive. She avoids her child’s creditors and potential ex-spouse. Another benefit is that the property does not have to go through the probate process at her death, simplifying the transfer and reducing the cost.
The life tenant retains any of the tax benefits of owning the house, and most importantly, the life estate is not a completed gift until the mother dies. That means the son can take advantage of the step up in basis and avoid potentially big capital gains taxes when he eventually sells the house.
Set up a Qualified Personal Residence Trust
Another way for parents to transfer their home to their children is through a Qualified Personal Residence Trust (QPRT). It is is an irrevocable (unchangeable) trust set up by your parents. When they put their home into the trust, it becomes a permanent (irrevocable) gift to the beneficiaries of the trust, who are usually one or more of the children. But this is not an immediate gift. When the trust is set up, it is set up with a time limit. The longer the time limit, the smaller the gift to the trust.
For example, if your father as donor was to transfer a $1 million residence to a QPRT, retaining the right to use the residence for a seven-year term, the value of the present gift to the remainder beneficiaries (the children) might be only fifty percent, or $500,000. If your father survives the seven-year term, the residence will not be included in his estate for tax purposes, nor will any of the appreciation in value of the residence occurring after the initial transfer. If, after seven years, the residence has appreciated in value to $1.4 million, the parents will have succeeded in transferring this amount to their children at the same tax cost as a transfer of only $500,000.
If your parents wish to remain in the house after the trust term has ended, they will have to pay rent to the beneficiaries of the trust (the children) to avoid any IRS question of an incomplete gift.
Agree to An Option Program
I had a client who had four children. None of them indicated in the family meeting that they were certain they wanted to buy their parents’ home, but they wanted to ability to do so in the future. They didn’t want the sale of the house to be automatic when their parents passed away. They agreed with their parents to set up an option program.
When their parents were gone, they agreed that a firm they were all familiar with would make an appraisal. That appraised value would be the price any of them had the option to exercise to buy the house. The option period would only be open for one year after their parents’ death. If none of the children had exercised the option by then, the house would be sold and the proceeds shared equally..
In this case if more than one of the children wished to buy the house it could be handled in two different ways. The sale could go to the highest bidder or the children could create a partnership agreement spelling out each of their responsibilities and buy the home as partners. It would be much simpler, however, if only one of them purchased the house.
Create a Family Limited Partnership
If your parents own rental property or some type of property that generates significant income, the situation can become more complex. Some of the children may wish to keep the investment property and some might just want to sell it to get the cash. One of the ways to make an illiquid real estate investment more liquid so the children have various options is to create a family limited partnership.
One of my clients owned a very profitable motel. By just overseeing the staff of the motel and working two or three days a week, he received a very handsome income. He decided he wanted to give his children the opportunity to keep the property and continue to receive a nice income. So he created a Family Limited Partnership. He placed the motel in the partnership. He and his wife became general partners of the partnership and his three sons became limited partners. Each of the partners owns a certain number of shares in the partnership.
In the beginning, my client and his wife owned all the shares, since they had owned the property. But over time they gifted shares in the partnership to their children. Thus, over the years, they transferred the ownership of the property to their children. Each child will own a certain number of shares in the partnership and can buy out his partners in the future. If one of the sons wants to maintain the property and receive the income, he can buy out his brothers. Or all three brothers could hire someone to run the property and receive the income based on the number of shares they own. The benefit of this solution is that the children have a choice.
The Bottom Line
Planning for the transfer of your parents’ real estate is one of the most important things a family can do. If parents and children talk to each other, and know each other’s needs and concerns, the valuable real estate can benefit the entire family. But if family members don’t plan together, this same valuable real estate can become the weapon that drives the family apart. That’s why it’s so important to invest the time and effort in working with a professional to create a real estate plan that works for your family.