Several times a week, people call the office to ask how they can add their child to their deed. I’ll usually ask “why do you want to do that?” And they will respond, “well, so when I’m gone, the property will transfer automatically.”
That’s a really bad idea.
When a parent puts their child on their deed, the transfer is a gift. When a child receives an interest in your house through your will, the transfer is an inheritance. Big, big difference.
Let’s say you bought your house for $200,000.00. After several years, you add your child to your deed, and some time later you leave this life. Your child is now the owner, but he already has a home, so he decides to sell your house immediately, and sells for $800,000.00. The transaction closes, and his attorney tells him “don’t forget to pay the capital gains tax!”
I’m sure all of you’ve heard of capital gains tax- it’s the tax that you pay on the increase in value of assets over the time that you owned it. Capital gains tax is calculated by subtracting the basis (what you paid) from the sale price. So, your son sold for $800,000.00 and the house was purchased for $200,000.00. The difference is $600,000.00, and current rates are up to 20%. Depending upon his tax bracket, your son could pay up to $120,000.00 in capital gains tax- and that’s federal- here in New Jersey, capital gains are taxed as ordinary income, when means up to 10.75%- that’s another $64,500.00! For those of you keeping score, from the $800,000.00 realized upon the sale of the house, your son is only keeping $615,000.00.
“But wait a minute! I only put my son’s name on the house a few years ago! Most of the gain was years ago!” Doesn’t matter. When you make a gift like this, your child inherits your basis- his basis is your basis- and he will have to pay the full tax.
Note that I’ve simplified this a bit- capital improvements over the years can be added to the basis, and the costs of sale (realtor commissions, attorney fees, etc.) can reduce the gain- but the tax bite is still incredible.
Now, let’s say you didn’t put your child’s name on the deed. Let’s say you left the deed alone, and simply wrote a will, naming your son as your beneficiary. When you pass, your son inherits the house, and just like before, he decides to sell immediately for $800,000.00. The difference here is that under these circumstances, there is NO capital gains tax.
“WHAT?! WHY?!”
The tax code provides a “step up in basis” when someone inherits property. That means that when your son inherits the house (as opposed to receiving his interest as a gift during your lifetime), his basis becomes the date of death value. He inherits at $800,000.00 (his basis), he sells for $800,000.00 and pays zero tax, keeping the whole $800,000.00. You just saved him almost $185,000.00!
So like my Grandpa Al used to say, “give it a thought.” You may think you’re doing something to make things simpler, but in reality, you could be creating a financial catastrophe.
