The most difficult part of an estate plan can be the family home or a second home. Often the property is a large part of the estate’s value. It also cannot be divided among the heirs. They either sell the property or share it. But the emotions surrounding a family property are probably the biggest reason that it can be a problem.
A number of strategies can help reduce the estate and gift taxes on a family homestead. But those strategies need to be combined with an understanding of the emotions involved. Estates large and small have been dissipated by legal fights over family homes.
Don’t think owning a modest house means this issue doesn’t apply to you. It often is lifelong rivalries and disagreements, some of which have been under the surface because of the parents’ presence, that trigger the behavior of siblings. Fights have been known to take place over trailers. It doesn’t matter whether the real estate was the principal residence, a vacation home, or undeveloped land. Siblings can find reasons to fight over it.
Fortunately, there is much you can do to avoid these fights. Here are some strategies to consider.
There are two additional strategies that both generate tax benefits and avoid some of the disputes that arise from inherited homesteads.
One option is the sale or gift of the property followed by a leaseback.
You sell or give the home to the children but you continue to live in the home. You either pay rent to the children or they make annual gifts to you of the home’s rental value (this likely would be tax-free because of the annual gift tax exclusion).
A gift of the home means either using your lifetime unified credit or paying gift taxes. If you sold the home, you might owe capital gains taxes but probably won’t under the tax-free sale rules.
In either case, the value of the home and the future appreciation are out of your estate. Your life hasn’t changed, because you still are living in the property. Plus, ownership of the property after you are gone is set, and you can help settle any disputes. It can be a kind of trial run.
You need a good lawyer to do this properly. Too many people don’t do the paperwork right and end up costing their estates a lot of money.
Another common strategy is the personal residence trust. You transfer the home to a trust but retain the right to use the home for a period of years. The period should be less than your life expectancy. After the period of years ends, the home belongs to your children.
You owe gift taxes for the portion of the value of the home the children will get. This will be less than the full amount of the home, since you will be using it for a number of years. The longer the trust term, the lower the taxable value of the home.
If you die before the trust term ends, there are no tax consequences to the transaction. The full value of the home would be included in your estate, and the estate would get a credit for any gift taxes paid. But if you survive the trust period, the property is out of your estate, including all the appreciation from the date of the gift to the trust.
Suppose you want to live in the home after the trust period ends. Your children will have the legal right to kick you out. To ensure that the strategy is valid, you must pay them rent or sign an agreement under which they let you live there rent-free as a gift. They would have a taxable gift to the extent that the annual rental value exceeds the annual gift tax exclusion.
Suppose a $250,000 home is put into a personal residence trust for 15 years, and the home is expected to appreciate 3% annually. In that case, the taxable gift on creation of the trust is $103,000. The rest of the home’s value avoids estate and gift taxes.
These strategies can be very effective ways to reduce your estate and gift taxes while settling how a family home is handled in the future. Be sure to consult an experienced estate planning attorney if they interest you.