A Major Estate Planning No-No

Portrait of family keeping their hands one another at home

Oh, my! I cringe every time I hear that someone has added their kids’ names to the deed of their house as an estate planning technique. It’s done for the right reasons, but it often backfires.

Sometimes, elderly people will add kids to the deed, thinking they’re removing the house from their assets in order to become Medicaid-eligible. Unfortunately, there are lots of rules regarding look-back periods and other issues that may pull the house back into the list of total assets even though mom or dad gifted the house away.

Another reason the kids are added to the deed stems from the belief that probate court costs will suck thousands of dollars out of the assets that are supposed to go to the heirs. Therefore, if the kids are already on the deed at the parent’s death, the kids own the house and everything is fine. Well, not necessarily.

First, probate may not be as big a deal as you think. Probate costs in most states run in the 3-5% range. And anything with a named beneficiary, such as retirement accounts, insurance policies, annuities, transfer-on-death (TOD) or pay-on-death (POD) accounts do not go through probate. They go directly to the beneficiaries. In some states, houses can be registered as TOD and do not go through probate.

But in states where TOD registration is not available, receiving a house while the owner is alive versus inheriting the house at death may create a substantial tax bill when the house is sold. If the house is gifted during the owner’s lifetime the heirs have a cost basis equal to mom or dad’s original purchase price. If the house is inherited at death the heirs receive a stepped-up cost basis, which is the value of the house on the date of death.

There are ways to pass a house to the heirs without awakening the capital gains beast. A home can be placed into a living trust, removing it from your estate at the time it’s transferred into the trust. The home can be sold in the future, after the original owner dies, and the sale proceeds then distributed to the heirs. By using the trust approach, the house receives the step-up in costs basis when the original owner dies and closely resembles what an outright gift does while eliminating many of the issues of a gifting strategy.

Another possibility is using a traditional life estate deed. The original owner can live in the home for their lifetime, but upon their passing, the life estate is terminated and the home transfers to the heirs. The house receives a full step-up in cost basis as of the date of the original owner’s death. There are some restrictions. The original owner does not maintain full control of the property after executing the life estate deed. They can live in the home, but they can’t sell the property, refinance it or take any other form of mortgage or debt against the property. A life estate deed is a legal transfer of the home at the time it’s executed.

Because the rules vary from state to state, it’s a good idea to get qualified estate advice. Doing the wrong thing for the right reason may cost your heirs in the long run.

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