Lisa was conflicted after having coffee with her mother this morning.  After all, this was her childhood home they were discussing.  Her parents  were in their mid-80s now, and wanted to get their finances in order “… because you never know.”   They were worried about estate taxes and probate and decided to transfer title to their home to Lisa and her sister.  She said it just seemed much simpler.  The conversation had upset Lisa because it was unexpected and it forced her to acknowledge that her parents were aging.

Lisa’s career as a real estate broker meant that her mother, and for that matter her friends and clients, considered her an expert in all things involving real estate and looked to her for advice.  Lisa knew this was an important decision and she needed help in advising her parents. After a couple of hours on the internet and a few calls to trusted advisors,  Lisa knew what she needed to tell her parents.  But first she needed to organize her thoughts.

Lisa discovered that this seemingly simple decision had serious tax implications which could result in  thousands of dollars in additional taxes. As she began to put her notes in order, Lisa realized that what she had learned would be beneficial, not only to her parents, but to friends and clients who might make the same mistakes her parents had almost made. She resolved to pass the information along.

Lisa quickly realized that estate and inheritance taxes are usually not a factor in the decision.  Recent changes in tax law increased the amount of property which may be passed at death free of estate taxes to $5,340,000 (2014 amount) per person. The tax free amount is indexed for inflation and is likely to increase each year.  Furthermore, married couples can transfer their tax free amount to each other at death with minimal effort which increases the amount a married couple can pass at death to $10,680,000 in 2014.  Lisa’s parents were comfortable, but they did not have that kind of wealth. Few people in Lisa’s circle of friends and family did.

A phone call to an attorney friend had unsettled Lisa.  As the lawyer began to discuss some arcane concept which he called a “step-up in basis” Lisa realized what a huge mistake her family had almost made.  Her parents bought their Austin home in the 1980’s for $100,000.  It was a small two bedroom west Austin home and they added a third bedroom for $50,000 shortly after the purchase.  Now the home was valued at $450,000.

Lisa learned that tax basis is used to compute capital gain when a property is sold.  Tax basis for a principal residence is the purchase price plus the cost of any improvements.  That meant her parents had a basis of $150,000.  If they gifted the property to Lisa and her sister, the basis of Lisa and her sister would be $150,000, the same as her parents. So if they sold the property after her parents death, their capital gain would be calculated by deducting their basis of $150,000 from a sales price of $450,000 and they would owe tax on $300,000.  At current tax rates, that could mean a tax of up to $75,000.

If Lisa’s parents kept the property and willed it to Lisa and her sister at their death, the lawyer said they would get what he called a “step-up in basis” to market value.  That resulted in a hugh tax savings. At current tax rates, maybe $65,000 to $75,000 in tax savings.   When her parents died,  the basis in the property would increase or “step-up” to the market value of $450,000.  When Lisa and her sister sold the property, there would be zero taxes due.  This alone meant that Lisa had to advise her parents to keep their home.  But there was more.

Since Lisa’s parents are over 65, they enjoy substantial savings in the ad valorem taxes assessed against their home.  They are entitled to a homestead exemption, which shaves $15,000 off the taxable value for school taxes and, in Travis County, a 20% reduction in taxable value on county taxes; an over 65 exemption shaves another $10,000 from taxable value and, more importantly,  freezes school taxes at the amount paid in the year of their 65th birthday.  Lisa’s parent’s school taxes have been “frozen” for over 20 years.  If they transfer the house  to their children, all of these tax advantages will be lost.

Lisa determined that if her parents needed to sell the house to move into assisted living, they could do so and still shelter all the taxable gain from selling the house.  The Internal Revenue Code allows a married couple to sell their home and shelter up to $500,000 in gain ($250,000 for a single person) if they have owned the house and occupied it as their primary residence for two out of the last five years. They don’t even have to buy a replacement residence to enjoy the tax savings.   Since her parents tax basis is $150,000 and the market value is $450,000, the gain from the sale would be $350,000.  The entire gain would be tax free.

If the property is gifted to Lisa and her sister and they need to sell the house to provide for their parents, they would not qualify for this tax savings.  It is not their primary residence.  They don’t even live in the house anymore. If Lisa and her sister sell the house, they will incur over $17,500 in capital gains tax.

The final issue her mother expressed concern about was the “medicare care tax”.  She said all of her friends were talking about it.  It did not take Lisa long to learn that the 3.8% tax on unearned investment income would not apply to the proceeds from the sale of her parents home, if they decided they need to sell.  Since the sale of their primary residence would not be taxable, there would be no tax due under the so called “medicare tax”.

The decision for Lisa’s family was clear.  Her parents should keep their home.  Lisa decided that she also needed to learn about probate.  Her parents had heard a lot horror stories and were concerned about how the process might affect her family.  But that is another story.

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