Real Estate Matters: A child is better off inheriting property instead of being put on title before parent passes away
Q: My dad owns a duplex. He lives upstairs and rents the downstairs unit. He wants me to inherit the property after he dies. Should we transfer ownership of the property by will or by adding me to the deed?
I understand all about how the stepped-up basis works on a primary home when someone inherits it. But this is different — at least, I think so. Then there is the $250,000 tax deduction you get on selling a primary residence. Would that apply to me if I were on the deed and he passed away?
A: You’ve asked some good questions, but haven’t given us quite enough information for a complete answer. So we’ll make a few assumptions about what you and your dad have in mind.
Let’s start with the $250,000 tax exclusion. It’s not a deduction. Instead, you get to exclude the first $250,000 in profit you make from any federal capital gains taxes that would be owed when you sell your primary residence. The one major rule on taking that exclusion is that you must have lived in that home as your primary residence for two out of the last five years. (Married couples get to exclude $500,000 from capital gains taxes on the sale of their primary residence.)
There are a few other rules that govern the tax exclusion, and you’ll find them reading IRS Publication 523: Selling Your Home.
Right now, your dad lives in one-half of the property. You don’t appear to live there at all. If your dad lives in one-half of the property, when he sells the building, he’ll only be able to exclude the profits earned on that portion of the property under the rules for the $250,000 tax exclusion.
But there are other ways for your dad to sell this property and maximize profits.
We have often warned parents not to add their children to the title of their home. Instead, it typically works better for a child to inherit the home upon the death of a parent because of the stepped-up basis. Why? If you inherit the home, it will be valued at the market price at the time of the parent’s death. If, for example, the parent purchased the home for $10,000 years ago, and at the time of death the property is worth $1 million, the child inherits the home at that value. When it is sold shortly after the parent’s death, the child would owe no federal income taxes.
It’s tempting to simply add a child to a property’s title. That does make it easier for the home to pass from the parent to the child. But you can also set up a simple living trust and deed the property into that trust. Upon the death of the parent, the trust can designate the child as the successor trustee and successor owner of the trust.
With this solution, you avoid probate court and the costs of probate by using a trust. On the other hand, you might have to pay an attorney to assist you in setting up the living trust and to transfer ownership of the home into the living trust.