Gifting residential real estate to one’s children and grandchildren is something many people wish to do and given the high cost of real estate in California, gifting real property is a favorite way to transfer wealth to the next generation with the added bonus that the child or grandchild gets use of a home that otherwise would be out of his or her reach.
Many parents also wish to reduce the size of their estate for estate tax purposes and consider a transfer during life a method to both benefit the next generation and save estate taxes. The tax benefits have been significantly reduced due to changes in estate tax and gift tax law as discussed below, but in areas of highly appreciated real estate, that benefit may still apply. Certainly, any further appreciation of the asset is no longer an increase in the size of the estate for estate tax purposes.
There are other benefits possible. At times, families want to own a second home to use as a vacation locale for the entire family, but one or more of the children may use it to live full time with others of the family having access for occasional vacations.
At times the parents which to have children assume the burden of ongoing maintenance and repair and taxes and are willing to gift the home to them in return for the parents continuing to occupy a portion of the property until death, benefiting both generations. An often understood if unstated condition is that the child occupying the home will take care of the parent if illness or old age requires it.
At times, the concept is to move income producing property (rental property) to children for their future income but during the parents’ lives the income comes in whole or part to the parents or the parents will live in one of the rental units for free.
There are many other varieties of how the property ownership may be structured, based on the unique goals, needs and desires of each family, but certain themes and problems occur which should be considered and addressed prior to title being transferred.
The transfer may have property tax ramifications, especially in the Post Proposition 19 world. California Proposition 19, effective January 1, 2021, allows the reassessment of real property for property tax purposes when transferring real estate from parent to a child. Previously, a parent could pass to their child a primary residence without any effect on the assessed value for taxes and could pass up to one million dollars’ worth of other real estate, such as a vacation home, with no reassessment. However, under the new Proposition 19, the only property that can pass without reassessment is a primary residence, and then it is the assessed value plus up to one million dollars. Vacation homes or other real estate are no longer protected from reassessment at all.
Further, the gift tax exemption, which applies to property transfers during life, is limited at the time of this writing to one million dollars and any value above that may result in gift tax being due and payable at the time of the gift.
Estate tax avoidance, which is a primary goal of most in making the transfer, assumes an estate tax that is not in constant flux. Sadly, that is not the case. Forty years ago, a transfer of two million dollars in an estate could result in a million dollars of estate tax. In 2020, the estate tax would be zero. The estate tax is altered on the average of every seven years and to make a gift now may make no tax sense in a decade down the road when the parent dies and the estate tax is actually due. And remember, if gift tax is due it is due and payable upon the gift being made, while estate tax, due upon death, may not be payable for decades.
But that tax liability may not be the greatest problem. If the property is transferred without written binding understandings as to rights, obligations and method of holding title, then common law rights such as the right to force sale via partition or unfettered right to use of entire property may interfere with the plans of the family and lead to disputes and litigation. Further, spouses of children or grandchildren, either now or in the future, may make claims on the property which the parents or grandparents did not expect when making the transfer. A gift made to encourage family togetherness or out of love can end up ripping the family apart.
This is not theoretical. A family, known to the author, transferred property to their daughter who then married X. The daughter and X used their earnings to maintain the property, make improvements and pay taxes. That made the contributions and part of the property their community property. X had an affair, the daughter ordered him out of the house. Since the property was at least partially community since he had contributed to taxes and improvements, he refused, telling her to move out if she was unhappy with him occupying a part. She refused and a cold war of mutual living in the home ensued. He upped the ante…having his new girlfriend move in with him, all three of them in the home the family had purchased and gifted. Since he owned a portion of the home, the court could not order him out. Finally, in disgust, she moved out and it took years to buy him out from his portion of the home and the parents had to help her.
It can happen to any family.
All this can be addressed and handled if considered carefully before the transfers occur and rights outlined in a binding agreement. The usual problems and the usual solutions are discussed in this article. Each family would be wise to get both tax and legal advice prior to making any such transfers.
The Goals and Common Issues:
It is important for the parents or grandparents currently owning the real property to carefully determine precisely why they are making the gift. The structure created and the rules concerning use will alter based on goals. As some examples of typical goals:
- The Simple Plan: The Child is Given a Home to Live In:
If the goal is simply to purchase a new home(s) for one or more children for the child’s use and to do it by outright gift, then the structure is simple: the home is purchased in the name of the child. The issue of ensuring that the property remains separate and is not converted to property owned by an existing or future spouse of that child will require some planning and drafting, however. The child should set up a separate account for all expenses for the home and the title should carefully state it is the separate property of the child. Ideally, the child will execute a prenuptial agreement if he or she later marries or remarries, and the future spouse will sign off that the property is separate. All this should be in a written agreement between the child and the parents if that limitation is important to them.
The gift is achieved by the parents gifting the cash (and sometimes their credit by co-signing on the loan) to purchase the home or at least make the down payment. Note that a problem that could develop is that in California earnings after marriage, absent a prenuptial agreement, are community property of each spouse and if the child uses those earnings to improve or pay for expenses of the real property, the spouse of that child could later claim some community interest. Either only separate property should be used for such expenses or the spouse must sign off on future community interest in the home.
Gift taxes could also be an issue as well as reassessment of the property and good tax advice should be obtained prior to the gifting. Subject to later changes in estate tax and gift tax law, a gift above a million dollars will result in gift taxes being due. And like the estate tax, gift tax is subject to change over time as the Congress determines.
Tax detriment can also be encountered by gifting. If one inherits property, one gets a new basis for capital gains purposes predicated on value as of date of death. All or most of the appreciation up to date of death does not count in determining capital gains. However, if one is gifted the property during life, then one must use the basis of the original purchase of the property. This can result in significant taxes being incurred in highly appreciated markets.
Another key issue is the possible effect on siblings and this is true regardless of how the gift is made. If one child is so favored and others are not, this can lead to tension and jealousy within the family. That should be confronted and discussed and, ideally, resolved prior to the gift being made. If there is good reason for the one-sided gift (the child has physical or mental needs greater than the other children; the other children are already well off, etc.) then that should be explained to the other children. Do not be surprised, however, if uneven gifting does not create resentment, even if there are plausible reasons to justify it.
Often parents will promise to make up the inequality in their estate plan. All should be aware that absent a written agreement as to what to put in the estate plan, that is merely an unenforceable promise…or, worse yet, an invitation for later litigation if the promise is not kept. This writer knows a family that ended up in vicious litigation when the later senile father failed to conform to his verbally promised allocation of gifts upon his death that he had made when fully competent a decade before.
And before the gifting parents try to “equal things up” by additional gifts to other children, remember that a gift is a permanent transfer. Once you gift it, you do not own it and if you need it back in the future due to changes in circumstances, there is no certainty that it will be returned…and if it is, then gift taxes may be due in paying the gift back! Look to your own budget and needs before you transfer substantial wealth to the next generation or any third party.
Do not assume anything. Do not assume that because children are close and friendly now that they will be so in ten or thirty years. Do not assume that spouses or children will not complicate the situation and perhaps cause disruption. Do not assume that what seems like a valid reason for unequal gifting strikes others as unfair and favoritism. And do not assume that things will not alter over time. If your own economic situation deteriorates, do not assume you can get the property back. Often…you will not.
By moving a home or the money to buy the home out of the estate of the parents, it is possible to reduce estate taxes. That can be a major benefit. The problem is that the estate tax changes over time while most taxes are only due upon the death of both parents which may be decades away…under a different estate tax regime. Get good accounting advice before assuming the tax savings is guaranteed.
- The Family Use Plan:
Often a family will want some type of access to real property being given away to a child or children. While the purpose may be to transfer an asset to children both to avoid some estate taxes and to give the child some hard assets to own, thus better credit, the parents and other siblings or relatives may want to have occasional use of the premises or to occupy a portion of the property whenever they wish.
This can be a vacation or resort home or condo or a home located in an attractive locale that other members of the family may want to visit from time to time. It may be a residence with few stairs so that an elderly parent can easily use it rather than the prior home. It may be a residence close to good medical care that a parent in the country may need from time to time.
Regardless, it is absolutely vital that a written agreement is entered into as to use of the premises. The alternative is likely unclear expectations as to current use and one must keep in mind that a decade down the road new persons, from grandchildren to new spouses, may be using the premises and that can lead to the new user having second thoughts about access and use. What if the new owner wants to sell or to rent a portion of the property; what if the new owner faces economic catastrophe so feels he or she must rent a portion or all of the property? What happens if the new owner dies and her husband inherits and he has no interest in having your family use the premises? What happens if the new owner is transferred to a new job and needs to use the equity to buy property in a locale that no one would want to visit? What happens if a new in-law wants to use and hates your family? What happens if the teenage son of the new owner likes large parties and noise while the grandfather wants a quiet retreat? Who ultimately decides?
Remember, in the absence of a written agreement, the title holders are the only ones legally entitled to use the property. Verbal assurances mean nothing. Unsigned promises mean nothing. A written agreement as to use which includes all possible variables must be executed to avoid later issues.
All this needs to be carefully discussed and reduced to a written agreement that each member of the family should sign. It will not be easy but keep in mind that as difficult as it may be now, it will be impossible if disputes or acrimony has already arisen.
And as to whether “your family” with its unique history of cooperation and love needs it. Well, in our experience those are precisely the families who need it most.
- The Quid Pro Quo Plan:
At times a parent or grandparent intends to use the eventual inheritance or use of the property to “pay” for ongoing care and help as the parent or grandparent ages. Indeed, a common arrangement is that the elderly parent will move into a room or adjacent structure while the younger family occupies the main house, invites the parent for meals and some socializing, and the parent or grandparent may live there for the rest of his or her life.
If that understanding is not reduced to a writing, it is not enforceable. Whoever is on the title documents has a continuing right to sole possession of the entire premises and may oust the other. And if the grandparent does not receive the care and consideration he or she thought she would and is no longer on title, that grandparent has no easy legal recourse to enforce that obligation.
Again, put it in writing or do not expect the courts to help you. Always.
One problem with the quid pro quo plan is that things can become much harder than one envisions when the property is transferred. A family known to the author were delighted with the arrangement when first created, with the elderly mother living in the adjoining small structure, sharing the making of dinners, taking care of the grandkids from time to time and her son able to live in a delightful neighborhood with good schools for his kids when that would have been impossible without the gift.
Then the elderly mother had a stroke which left her deeply impaired and no longer capable of helping in the least or even going up a flight of stairs to the main house. She required full time care and there was no place for her care giver to live in the small adjacent home. Further, her personality, not surprisingly, became extremely negative and demanding and she complained constantly as to the noise the children made.
She insisted that her son move out of the main home after some months of this and when he refused demanded that he purchase a condo she could use. He simply could not afford that additional cost and the situation became even more tense. The living arrangement became impossible for all of them and the son, who loved his mother, ended up selling the home and giving a portion to her to purchase a condo. She was not happy with the relatively small amount she received but as we advised her, he was on title and could easily have refused to help her at all in the absence of a written agreement as to duties and rights. The family never recovered from this dispute and even after her death a year later, his siblings blamed him for “taking advantage” of her and one even accused him of contributing to her death.
Quid Pro Quo plans can work but once again a full and complete discussion of all ramifications of the transfer and rights and obligations in the future must occur within the family and that should be reduced to a writing. The potential problems that can arise…such as ill health, a transfer to a new location, a divorce or a disability…must be considered and factored into the agreement.
Does Every Family Need Such an Agreement?
A common response we hear when we advise families is that the family is so close and loving that such an agreement will not be necessary. Indeed, to reduce the understanding to a written agreement is almost an insult to the family which has always taken care of its members.
The law will not care much if the family was always loving in the past. The law will look to the written binding agreements and while a family member can try to enforce a verbal understanding, that will be extremely difficult if not impossible. Families change. That is life. You do not know who your son or daughter will be married to in a decade and that new spouse may alter the dynamics. Your grandchildren may slip under the influence of people you detest or fear. You may suffer Alzheimer’s or senility and become someone your family finds impossible to live with. If you want to truly take care of yourself or your family, then such possibilities should be addressed now, not when you no longer can.
As one client put it in an e mail to the writer, “A gift that can blow the family apart is not a gift. Part of my duty is to do it right to minimize that chance….”
If the gift was already made, the family can still enter into a full written agreement to avoid future problems…but the bargaining may be very different since the gift is completed. If nothing else, a failure to create the right structure after gifting is complete should make it clear that trouble may be brewing in the future. The very attempt may educate all as to future issues that perhaps can be avoided if confronted now.
A Gift is Just That-a Gift.
A gift is a permanent event, even if made to a family member. Once you transfer property, under the law you no longer own it and your claim that you want it back confronts the simple fact that the law does not transfer back property absent a showing of fraud in inducement of transfer and such an action is very, very difficult to advance, as well as costly in a court of law.
Somehow, many seem to feel that a gift is not as binding as a sale or purchase of property. That is simply untrue. The law will enforce rights granted via gift as readily as rights obtained through purchase.
And promises that they will transfer the property back to you, if unwritten, are unlikely to be enforceable. It is vital for the giftor to realize that once the gift is made, it is as “real” as if you sold the property to a third party rather than a family member. And if by chance your son or daughter transfers it back to you…well, that could be a gift taxable event in itself.
A gift…is forever, even if you change your mind.
It is not difficult to avoid the bulk of the problems recited above. One enters into a written agreement providing for the various issues that can arise and giving each party a legal remedy if the agreement is broken. A good idea is to provide for mediation and (if unsuccessful) arbitration of all disputes to avoid the expense of a court of law.
Such an agreement should be created with good legal and tax advice and should confront all those issues that, however uncomfortable, should be dealt with prior to their actually arising…death, disability, divorce, bankruptcy, creditor liens, all the unpleasant things that sadly do happen and can alter the foundation of the entire arrangement. Any experienced attorney can create fair terms that address those issues and any good accountant can give the tax advice vitally necessary.
If such an agreement is not chosen as the appropriate instrument, then the person gifting should reconsider whether a full gift should be made. A conditional gift…e.g. the home is transferred if all expenses are met for X amount of time and if the grantee also provides Y support for the grantor…can be used but, in reality, this is simply another form of written arrangement.
Living Trusts may be an excellent way by which the property remains owned by the giftor until death or some event occurs and is then transferred to the next generation assuming various conditions occur. Such a gift to a trust may be made irrevocable, assuring the next generation of obtaining it but only if conditions are met. Before such irrevocable trusts are created, the wise giftor will obtain appropriate advice. Note that there may be limitations on various tax benefits if that trust structure is used.
If you are the person receiving the gift, know that absent a writing committing ownership to you either now or in the future, promises to leave you property are usually not enforceable. All too often our office hears from a son or daughter, outraged that the mother or father left the property to a third party and not to them in a will or trust, despite promises made over the years. More often than not, a new spouse of the decedent obtains the property to the chagrin of the son or daughter.
This does not mean that they are evil or manipulative. It means they have changed their mind and usually they have every right to do so, absent a binding agreement to the contrary. While arguments of reasonable reliance by the son or daughter can be advanced, especially if they took economic action based on the promise, such cases are very difficult to win. If the son or daughter put a new roof on while not living there, expecting to inherit, the court is just as likely to require the new owner to pay the cost of the roof back rather than transfer title.
Above all, the family will be fractured and the lawyers earn a great deal of money if such a fight is taken to court. And all that could have been eliminated or the danger reduced if the family had met, discussed and implemented a written plan at the beginning.
Want to rely on promises made as to real property or inheritance?
Get it in writing…