I own a rental home in California. How can I leave it to my daughter to avoid capital gains tax?


I live in California and own a single family rental property that has a tenant with a renewable 12 month lease. The house is in a revocable trust.

I would like to leave the property to my daughter. I have another child to whom I do not intend to leave this property.

My daughter will likely keep the rental property, but could use it as a second home and / or a partial weekly vacation rental.

How do I structure my will to leave the property to her so that she can avoid probate and the payment of capital gains tax?

Truly,

THE landlady

“The Big Move” is a MarketWatch column that examines the ins and outs of real estate, from finding a new home to applying for a mortgage.

Have a question about buying or selling a home? Do you want to know where your next move should be? Email Jacob Passy at TheBigMove@marketwatch.com.

Dear landlady,

Since I started this column about a year ago, one of the most common questions I get has been about how best to leave a home for your children. Parents recognize that real estate is a useful way to build generational wealth and they want to make sure their children get the most out of their inheritance.

It makes sense that you want to avoid probate – in many states, this is an expensive process and the fees involved can eat away at the value of the estate.

Your situation is a little more complex, however, because the property is not your main residence, but rental accommodation. There are therefore different considerations involved.

I have interviewed financial advisers for different strategies that address your concerns. The first and potentially the easiest option, which was presented to me by David Bize, a certified financial planner based in Texas, is to convert the deed of ownership to a revocable death certificate transfer. This option became available in California in 2016 and is available in 25 other states, as well as the District of Columbia.

This deed allows you to leave your property to a designated person, in this case your daughter, without the need for a trust. Because of the way the deed is structured, the house would not go through probate. Unlike a joint deed, adding it to that deed as a named beneficiary is not a taxable event in the eyes of the IRS.

There are still some drawbacks. For example, if you become disabled due to an accident or a health problem such as a heart attack, your daughter might not be able to revoke the act on her own. This could complicate matters, as it may be necessary to qualify for Medicaid.

Another common strategy people use to bypass probate, and one that has been recommended to me by many financial advisers, is putting a house in trust, as you have already done.

But there are potential pitfalls, especially in the form of capital gains taxes. After your death, your daughter may want to sell the property rather than keep it. If she were to inherit it by will and probate, she would then be entitled to a basic increase. This means that instead of the original price you paid to buy the rental home, the value of the home at the time of your death would be used to calculate the base cost (plus any expenses related to improvements or maintenance.)

If the property’s value has appreciated significantly over the years, that could make a major difference, and without the increase in base, it could be liable for tax on hundreds of thousands of dollars in profits. .

The form that trust takes is critical here. “Assets that bypass the estate through a trust or other mechanism are generally not eligible for a base increase,” Kristin McKenna, managing director of Darrow Wealth Management, wrote in a blog post. However, a home held in a revocable living trust would likely qualify for the base increase.

A final strategy recommended by several advisers was to turn the house into a limited liability company, or LLC. This route would also have benefits for you during your lifetime, as it protects your personal belongings from liability in the event of financial or other issues related to the rental of the house. In addition, LLCs can benefit from better tax treatment in certain cases.

You could then place the LLC in a revocable living trust, or simply create a clause in its operating agreement that states inheritance to your daughter in the event of death.

“There could be complications if there is a mortgage on the rental property, so this needs to be taken into account,” warned George Gagliardi, founder of Coromandel Wealth Management in Lexington, Mass.

Before you start working on this plan, it can also be helpful to determine exactly what your daughter wants to do with the property after you die. Proposition 19, which passed in California in 2020, has very serious ramifications for people who inherit valuable investment property.

“If your children decide to rent out your house after inheriting it, they will pay property taxes based on the market value at the time of inheritance (the appraised value would equal the market value),” Chris Jaccard, Senior Advisor and Partner from the wealth management company Financial Alternatives. , wrote in a blog post.

Families had until mid-February of this year to transfer ownership to their children and keep the original property tax rate. For example, for a house worth $ 2.1 million, you might only pay $ 4,000 in annual property taxes, but it will go up to $ 21,000 if your daughter continues to rent it ( since that’s 1% of the assessed value.) If she lives in the house, she might also see an increase in property tax, depending on its value.

If it seems like her best option is to sell the house, then she should go with the strategy that ensures she pays the least capital gains tax. Given the nuance here, I would suggest consulting with an attorney familiar with estate law to clarify the terms of the trust in which the house is already held and what the tax implications are.

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