Capital Gains on Inherited Property

My clients often ask me if I can explain the difference between transferring land directly to their kids while they are alive versus transferring it via a life estate deed.

I have this conversation several times a week.

First, let’s define the two types of transfers.

Deeding real property via a regular Warranty Deed or Quit Claim Deed to a person involves you, the grantor, giving all of your rights and interest in a piece of property to another person, the grantee, without any delay or without retaining any rights.  The person owns the property, in full, and unless you specify it on the deed, you have no further ownership in the property once you sign the deed and give it to that person.

Deeding real property via a Life Estate Deed gives you, the grantor, the right to own the real property during your lifetime.

You retain the right to own the real property, and are responsible for taxes, upkeep, etc. on the real property until the day you die.   Once you pass away, the person you deeded the property to, the grantee, owns the land outright.  All they need to do is file your death certificate in public land records and your name is removed from the real property.

So, what are the pros and cons of each?

There are many.  But in this column, I am only going to talk about the capital gains issue.

Let me explain with an example:

Mom and Dad want to give their son a piece of property they bought in 1965 for $25,000.  They sign a quit claim deed and give it to the son, who pays nothing for the property, which is now worth $250,000.

The son then tries to sell the real property a few months later and finds out that he may be facing capital gains taxes on the real property that sets the value of the property at the 1965 price.

Namely, potentially paying capital gains taxes on a $225,000 profit. ($250K – $25K)

Why?

Because the sale of such property is usually considered the sale of a capital asset and may be subject to capital gains treatment.

In the alternative, Mom and Dad decide to retain life estates in the property when they transfer the land to their son, and when they die, the son owns the property in full.

The Internal Revenue Code provides that the basis of property acquired from a decedent is its fair market value at the date of death, so there is usually little or no gain to account for if the sale occurs soon after the date of death.  This includes life estate deeds that pass to the grantees when the grantors die. (in other words, from Mom and Dad to the son when both parents die)

Mom dies first, then Dad dies.  The son gets the real property appraised at the value of the property on the day Dad dies, which is $250,000.

The son sells the real property for $250,000.  His potential capital gain on the real property is $0.

Why?

Because as the child inherits the property at the time of his parents’ death, the child will enjoy stepped-up tax basis and avoid capital gains taxation.

Now this is the 30,000 foot simplified view of the subject, but as you can see, merely deeding a piece of real property to your kids without retaining a life estate could cost them quite a bit in taxes later on down the road.

So, if you’re thinking about deeding property to your kids before you die, it would be wise to speak to an experienced estate planning attorney regarding the different types of deed transfer and what works best for your Estate Plan.