The strategy of gifting the family home to the next generation as your parents mature is fraught with possible pitfalls. Yes, it may save the home’s value from being consumed for long-term health care issues, and in the end, that may or may not matter.
Consider the case where the home is your parent’s major asset. If they’ve owned it for a long time, chances are that their tax cost is far lower than the current fair market value. Too many attorneys give the advice to get this home out of the parent’s names to protect that asset from paying for the health care, and that may turn out to be bad tax advice.
When a home is gifted, the tax cost in the hands of the recipient is the same as it was in the hands of the grantor former resident of the home.
This means that when the home is ultimately sold, there could be significant capital gains tax to be paid on the entire amount of the gain.
Two alternatives exist.
First is to sell the home as the personal residence of your parents while they are alive. This means that they’ll have the tax savings benefit of excluding up to $500,000 of any gain. If only one parent is living that exclusion drops to $250,000. There is no exclusion to you if you sell after their passing and it is not your primary residence for the past two years. You can then gift the net proceeds from the sale if your objective remains to protect the assets.
The second alternative is to allow your parents to stay in the home, rent free after the deed is transferred to the children. This alternative creates what estate planning professionals call a life estate. That means that you’ve given the right to your parents to live in the home for their entire life. While you technically own the property, a life estate is considered an asset of the deceased after they pass.
This is a good thing if you’re looking to take advantage of the rules for a stepped-up basis. A step up in basis means that the tax cost of the property in the hands of the recipient is the fair market value on the date of death. This typically means that there will be little to no gain if you sell the home shortly after their passing.
In most cases, the primary purpose of this strategy is to protect the home from health care costs. This may work, but what about the health care needs of your aging parent? Most children don’t want to see sub-par care or their aging parent just so they can inherit a house. The worst of all worlds would be for the children to pay for that care out of their pocket and then sell the home and incur a large tax bill. Get competent advice before you change that deed.
