When it comes to estate planning, we regularly encounter clients anticipating the need for nursing home care. As we’ve previously stated in other articles, our firm can assist clients with protecting their assets from Medicaid spend down requirements, allowing them to qualify for Medicaid (pay for nursing home care), without “going broke.”
Usually during these conversations, a client will ask “should I gift my house to my child.” My answer is always NO. First, gifting is subject to the same five-year lookback requirement for Medicaid qualification. Second and more importantly, gifting is what we lawyers like to say non-take-back-able. That is to say, once you’ve given the asset away, there’s no getting it back without the recipient’s consent. An asset trust, on the other hand, allows you to convey the property to the trust and still retain the benefit of living in the home, retain the income rights if the home is ever rented out, and ensure the house passes in accordance with your final wishes, all while protecting the house from being sold to pay for your long term care.
But there’s another big reason not to gift your home, and it has to do with taxes. When you gift something to your children (or anyone), a couple of things happen. 1) If the gift is more than $15,000, you must pay a gift tax and 2) the recipient inherits your cost basis. We will focus on the cost basis issue in this discussion.
Let me explain with an example. You purchased your home in 1989 for $100,000. This $100,000 is your cost basis (AKA tax basis). Now the house is worth $300,000. The $200,000 of growth on the value of your house are your gains. Essentially, you take the current value of the home, subtract your cost basis and this gives you your gains.
So in our example, $300,000 (present value) - $100,000 (cost basis) = $200,000 (gains)
If you sell your home, you will have to pay taxes on these gains. Probably 15%-20%. In this example, you would owe approximately $30,000 in capital gains taxes to the federal government. Of course, if it is your primary residence, you will likely be able to avoid paying those taxes, thanks to the primary residence exclusion. This would not apply to rental properties, undeveloped land, or other appreciated assets.
What if you gift the house to your child? They will receive your same cost basis, $100,000. Now when they sell the home, they will have to pay those same capital gains taxes. And they are unlikely to qualify for the primary residence exclusion.
Now let’s look at what happens if they inherit the property through an asset trust, upon your death. The house is protected from Medicaid’s spend down requirement, so long as it has been in the trust for five years. The house remains in the trust, to be used however you see fit, until you pass away. Then your child inherits the house. Unlike gifting, inherited property receives a “step up in basis.” When the property passes to the beneficiary, the cost basis is “stepped up” to the fair market value. Let’s see how this plays out in our prior example.
The house is worth $300,000 at the time of your death. But instead of the cost basis being $100,000, it is now $300,000. When we run through our calculation, we get an interesting result.
$300,000 (present value) - $300,000 (stepped up cost basis) = $0 (gains)
When your child sells the property, they will pay $0 in capital gains taxes, assuming the sale price is the same as the cost basis. Of course, if they hold the property and it continues to increase in value, they may need to pay capital gains taxes on the excess over $300,000. In any case, they have avoided paying taxes on $200,000 of capital gains.
We could take this scenario even further. What if the child held the property and it depreciated in value for some reason, down to $200,000. If you had gifted it to them, they will still have $100,000 in gains, on which they will be taxed. But if they inherit the property and receive the step up in basis, they now have a $100,000 capital loss, which they can use to cancel out capital gains that might have been realized elsewhere (e.g. the sale of appreciated stocks).
Lastly, this concept is not limited to your primary resident. Perhaps you have some ancestral real estate of tens, hundreds or even thousands of acres. Perhaps you bought $100 of Amazon stock for $2 per share in 1997 that is now worth somewhere around $165,000. Those are some serious capital gains!
All of these appreciated assets are eligible for a step up in basis, if they are inherited. But the step up in basis does not occur if the asset is gifted during your lifetime.
To be clear, gifting sometimes makes sense, particularly if the anticipated value of an estate is high (over $24 million for a married couple). We always recommend consulting your tax advisor for your specific situation. However, we have found that the step up in basis is a huge saving to the vast majority of our clients.
This is just one more example of why professional estate planning is so important and can save you and your family thousands (or more!) in the long run.