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December 11 2008

Conveying Real Property "“ Consider the Consequences First

By Neil L. Kimball

Many individuals, typically parents, desire to convey certain real property to their children during the parents’ lifetime because they want to make certain that the property does not pass through probate proceedings at their death or because they want the children to have the use of the property during their parents’ lifetime. However, one important tax consideration is often not taken into account. If the parents deed the property to a child during the parents’ lifetime and the parents do not stay on title as a joint owner, then the children receive the property with the same tax basis that the parents had in the property. The tax basis is essentially what the parents paid for the property plus any capital improvements to the property (such as additions to buildings or other improvements on the property). Typically the parents’ tax basis is very low in relation to the property’s fair market value. Then if the child eventually sells the property, the child will pay capital gains on the difference between the fair market value at the time of sale over the amount of the parents’ tax basis. This can result in a substantial tax bill to the child.

However, if instead of deeding the property outright to the children, the parents deed the property to the child and the parents as joint tenants with rights of survivorship, then when the parents die, the child will inherit the property without probate proceedings and the child will have a basis in the property equal to the fair market value of the property at the parents’ death. In other words, the parents’ tax basis “steps-up” to its fair market value at the date of the parents’ death. When the child then later sells the property, the child will pay capital gains only to the extent of any appreciation in the property after the date of the parents’ death rather than paying capital gains on the amount equal to the fair market value at the date of sale over the amount of the parents’ original cost basis. In short, by the parents’ staying on title with the child until the parents’ death, a large capital gain can be avoided.

There are certainly other factors to take into consideration in determining whether or not the parents should make an outright conveyance or stay on title with a child. For example, if the parents deed the property jointly between the parents and the child and the child is going to be utilizing the property, the parents bear some liability exposure risk if the property is negligently maintained and someone is injured on the property. Also, to the extent the parents stay on title to the property, the entire value of the property will be included in the parents’ estate for estate tax purposes at the parents’ death. This is not a problem if the parents’ estate does not approach the current applicable exemption amount at the parents’ death. Currently, a single parent can leave as much as $2 million to heirs or other beneficiaries at their death without any estate tax applying. If a parent has a relatively modest estate that does not approach the $2 million exemption amount, placing the property jointly between the parents and the child will not have any adverse estate tax consequences.

In conclusion, any transaction with respect to real estate should take into account many different factors. However, the most commonly ignored or misunderstood factor is that an outright conveyance to a child or other individual may result in a substantial capital gains tax that might otherwise have been avoided through joint ownership.