Most people have heard of the nightmare that is California’s probate court, and in an attempt to make sure that their estate does not have to pass through the probate process decide instead to gift their assets to their children prior to death, either outright or in joint tenancy. No estate, no probate- simple as that. People will add their children onto the title of their real property, or even deed the entire interest. They will add children onto their bank and brokerage accounts as co-owners, or often directly gift large sums of money to lessen the size of their estate. While it is true that this course of action will generally accomplish the goal of probate avoidance, there are some very serious potential consequences to this course of action that should be taken into account prior to completing it.
Carry-Over Basis for Capital Gains Tax Treatment.
Pre-death gifting of appreciated capital assets (real property, automobiles, investment accounts, etc.) can result in unexpected and avoidable capital gains tax liability. A capital gain is the difference between the cost basis of the asset (basically, the acquisition price of the asset adjusted for such things as depreciation, capital improvements and dividend reinvestment) and the sales price of the asset. Capital gains are taxed at a top marginal rate of 33% for capital gain for a California resident (taking into account federal and state rates). When property is gifted prior to death, the recipient of the gift retains the same cost basis that the gifting party had on the property, referred to as “carry-over basis” treatment. However, if property is instead gifted at death as an inheritance, the beneficiary of that asset gets a “stepped-up basis” in the property, meaning that the beneficiary’s cost basis becomes the value of the property at the date of transfer (date of death). Let’s say a person acquired a house in 2000 for $300,000, and that house is now worth $600,000. If the person gifts the house to his child, the child receives the property with a cost basis of $300,000, and if the child then sells the house for $600,000 the child will pay up to 33% of that $300,000 gain ($99,000) in capital gains tax on the sale. If the person instead names his child as a beneficiary of the property in his trust, and the property is inherited by his child on his death with a date of death value of $600,000, the child’s cost basis will “step up” to $600,000. If the child sells the property at that time, there will be no capital gains tax due, a potential $99,000 savings. Avoiding probate by gifting would clearly backfire from a financial standpoint in this scenario, and alternate probate avoidance methods (for instance a revocable living trust) would be a much more responsible way to go.
Loss of Control.
Several years ago we encountered a situation where a woman added her daughter to the title of her home as a joint tenant so that the property would pass immediately to her daughter on her death. Subsequently, the woman decided that she wanted to sell her home and move to a smaller, more manageable living situation. However, her daughter liked the home and refused to sell her interest, essentially blocking her mother’s sale of the house that she had worked so hard to acquire. Predictably, this was the only asset that the daughter ended up inheriting from her mother. By adding her daughter onto the title of her home, she lost the autonomous control of her own property, with disastrous consequences.