A lot of people come into my office and ask me if they should transfer their real estate into their kid’s name while they are still living. Here is the typical reason they give for wanting to do that: If my child goes on the title to the property, (1) I save money by not paying an attorney to draft a living trust, and (2) I avoid having to probate the property since title is already in my child’s name. Although transferring title to a child or loved one while you are living could save you money by not paying an attorney and you could avoid probate by transferring title to your child now, there is an organization these people forget that will take more money than the attorney and the probate process combined: Good ol’ Uncle Sam through the IRS.
Every time a person does this kind of transfer, Uncle Sam does a happy dance and throws hundred dollar bills in the air. He’s dancing because you just gave away a tax shelter you were entitled to take, and you stepped up the basis upon your death for capital gains.
Here’s how the stepped up basis rule works. Imagine you bought your house 40 years ago, say for $20,000. The property at the time of your death is now worth $400,000. Your basis in the property is $20,000, and the taxable portion upon which the IRS can base any capital gains for your house is $380,000. With the stepped up basis rule, your basis in the property reappraised and reset to the present fair market value at the time of your death. That means that instead of a basis of $20,000.00 when you purchased the property, your basis is $400,000. The effect of a basis shift at the time of death is that if your heirs or beneficiaries sell your property relatively close to your death, little to no capital gains would be due since you would have no gains due to the fact that your basis was stepped up to the current market value. That keeps more money in your family’s pockets.
The individuals that transfer their property to their kids when they are living lose this step up basis treatment. The IRS rule actually punishes you for making a transfer like that since the law states that your kids would inherit your cost basis of the property. That means that if your kids sold the property at the time of your death for $400,000 with a $20,000.00 basis, the taxable capital gains value would be $380,000. For most individuals, the rate for long-term real estate holdings is 15%. So assuming a 15% tax rate, get ready to send Uncle Sam a check for $57,000 on a $400,000 sale! That’s a lot of money just to avoid paying an attorney $1,000–$2,000 to prepare an estate plan.
You can avoid giving the IRS this money and avoid probate by having an estate attorney prepare a good estate plan. We typically start by setting up a living trust or using a transfer on death deed to avoid probate while still preserving the right to use the stepped up basis mentioned above. I know going to attorney to have all the required documents drawn up might be a hassle at first, but do you want Uncle Sam doing a happy dance at your expense? Don’t give Uncle Sam extra money when you don’t have to.
