I own a rental home in California. How can I leave it to my daughter so she can avoid capital gains taxes?

My daughter will probably keep the property as a rental, but she might use it as a second home and/or as a partial, week-to-week vacation rental.

How do I structure my will to leave the property to her so she can avoid probate and paying capital-gains taxes?

Sincerely,

LA Landlady

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Dear Landlady,

Since starting this column about a year ago, one of the most common questions I get is about the best way to leave a home to one’s children. Parents recognize that real estate is a useful avenue toward building generational wealth, and they want to ensure that their children get the most out of their inheritance.

It makes sense that you want to avoid probate — in many states, it’s a costly process, and the fees involved can eat into the value of the estate.

Your situation is a little more complex though, because the property isn’t your primary residence, but a rental home. So there are different considerations involved.

I polled financial advisers to get different strategies that address your concerns. The first and potentially easiest option, presented to me by David Bize, a certified financial planner based in Texas, is to convert the property’s deed into a revocable transfer on death deed. This option became available in California in 2016, and is available in 25 other states, plus the District of Columbia.

This deed allows you to leave your property to a designated individual, in this case your daughter, without the need for a trust. Because of the way the deed is structured, the home wouldn’t go through probate. Unlike a joint deed, adding her to this deed as your designated grantee isn’t a taxable event in the eyes of the IRS.

There are some drawbacks, though. For instance, if you were to become incapacitated due to an accident or a health event such as a heart attack, your daughter may not be able to revoke the deed herself. That could complicate matters, because doing so might be necessary to qualify you for Medicaid.

Putting a home into a trust, as you have already done, is another common strategy that people use to bypass probate, and one that was recommended to me by many financial advisers.

But there are potential pitfalls — namely in the form of capital gains taxes. After you die, your daughter may wish to sell the property rather than hold onto it. If she were to inherit it through your will and probate, then she would be entitled to a step-up in basis. What that means is that instead of the original price you paid to purchase the rental home, the home’s value at the time of your death would be used to calculate the cost basis (plus any expenses tied to improvements or maintenance.)

If the property has appreciated significantly in value over the years, that could represent a major difference, and without the step-up in basis she could be on the hook for taxes on hundreds of thousands of dollars in profit.

The form the trust takes is critical here. “Assets that bypass the estate through a trust or another mechanism are usually not eligible for a step-up in basis,” Kristin McKenna, managing director at Darrow Wealth Management, wrote in a blog post. However, a home held in a revocable living trust likely would be eligible for the step-up in basis.

One final strategy multiple advisers recommended was to put the home into a limited liability company, or LLC. This route would have benefits to you in your lifetime, too, because it protects your personal assets from liability were any financial or other problems to arise in conjunction with the rental home. Plus, LLCs can attract better tax treatment, in some cases.

You could then place the LLC into a revocable living trust, or simply create a clause in its operating agreement that stipulates succession to your daughter in the event of your death.

“There might be some complications if there is a mortgage on the rental property, so that needs to be considered,” warned said George Gagliardi, founder of Coromandel Wealth Management in Lexington, Mass.

Before you get to work on this plan, it might also be worthwhile to nail down exactly what your daughter wishes to do with the property after you die. Proposition 19, which was passed in California in 2020, has some very serious ramifications for people who inherit valuable investment properties.

“If your children decide to rent your home after inheriting it, they will pay property taxes based on the market value when inherited (the assessed value would equal the market value),” Chris Jaccard, lead adviser and partner at wealth management firm Financial Alternatives, wrote in a blog post.

Families had until mid-February of this year to transfer property to their children and retain the original property tax rate. For example, for a home worth $2.1 million, you might be only paying $4,000 in annual property taxes, but that would go up to $21,000 if your daughter keeps renting it (since it’s 1% of the assessed value.) If she lives in the home, she could also see an increase in the property tax, depending on its value.

If it appears that her best option is to sell the home, then she should opt for whatever strategy ensures she will pay the least amount in capital gains taxes. Given the nuance here, I would suggest consulting an attorney well versed in estate law to clarify the terms of the trust the home is already held in and what the tax implications are.

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