Trusts and Capital Gains Taxes

A Bad Mistake. One of the worst estate planning mistakes a person can make is naming their children as coowners of assets.  Many people believe that naming a child as a co-owner of an asset will avoid probate or make payment of bills more efficient.  This is sometimes true (but not always).  The problem is that co-owned assets (whether real estate, bank accounts, or any other asset) most often result in capital gain taxes that are completely avoidable. 

One story.  Mom thought she would be nice, so she put the names of her four daughters on her deed to her residence.  She died.  Daughters inherited her basis (the price she paid for the house 37 years before), so when daughters went to sell the residence, they realized a significant capital gain and a $24,000 capital gain tax.  This tax (and probate) would have been completely avoided if mom had just kept the deed to the residence in the name of her trust! 

How Capital Gain Taxes Work.  To understand what Mom did wrong and how to prevent it, we need to understand a few terms. First, the word “basis” means the price you paid for an asset.  For example, if you paid $100,000 for your home, then your basis in the home is $100,000.  The term “fair market value” (or “FMV”) means what the home would actually sell for on a particular date.  So, if your home could sell today for $200,000, the fair market value of the home today is $200,000. 

Now, if you file a deed with the county recorder, putting your name and the child’s name on the deed as coowners, then at that moment your child inherits your basis in the home.  Your child’s basis in the home is your basis. 

With these definitions in mind, let’s run a scenario.  When you die, let’s suppose your home is worth $250,000, and your child is living in his or her own home. Your child would have a basis in your home of $100,000. Your child would then sell your home for $250,000, thereby experiencing a taxable capital gain of $150,000.  Your child would then be required to pay a capital gain tax, currently 15% of the capital gain, but likely to rise to 20 to 28% shortly.  So, your child would pay a minimum of $22,500 in this example.  That is a problem. 

How to Use a Trust to Avoid Capital Gain Taxes.  The way to avoid this problem and avoid probate is to file a deed with the county recorder naming your revocable trust as the owner of your home.  Then, by law, upon your death, the basis in your property “steps up” to the fair market value of the property as of the date of your death. So, if your basis is $100,000 and the fair market value of the property at your death is $250,000, then at your death, the basis in the trust-owned home “steps up” to $250,000.  Your child then sells the house for $250,000 and there is no capital gain or probate.  This strategy applies to any asset that has a capital gain attached to it, real estate, stock, investments. 

It is generally a good idea to have your trust own such assets, not your children! Of course, this is general information and may not be appropriate in your situation.  As always, the safest thing to do is to contact a competent estate planning attorney, regarding your unique situation and questions. 

Good Planning and Taxes. There are numerous ways to accomplish sound financial and estate planning and save taxes at the same time.  Estate and gift taxes, income taxes, and capital gain taxes can be minimized, and in some cases eliminated, with a combination of good financial and estate planning, all while benefitting your loved ones.