One of the best kept secrets in estate planning involves the use of something called a Revocable Transfer on Death (TOD) deed. It has the affect of transferring the title of real property to a beneficiary, the same way financial accounts or life insurance are paid to a beneficiary. This is an extremely effective, and cost efficient way of transferring what is typically a person’s largest single asset.
Occasionally, someone will come to me with a request to draft a new deed to her home in order to add her child. She knows the property would avoid probate if it is transferred to a co-owner with a right of survivorship. However, what they don’t usually understand is that adding someone to a deed while they are still alive could result in a much larger tax bill when the child goes to sell the home.
While a transfer to a child is often an exempt transaction for transfer/recordation taxes, the transfer is not afforded something called “step up basis.” The basis of one’s home is the price or fair market value at the time a person acquires it. Under current tax rules, a single person or couple can see an appreciation in value at sale of $250,000 or $500,000 respectively, before any capital gains taxes are owed.
For example, if a couple bought a home for $500,000 and 20 years later they sell it for $1,000,000, no capital gains taxes will be owed. This is an oversimplification because there are other factors like using it as a primary residence, etc. Still, this is the case for many couples.
But, let’s change the example, let’s assume the husband dies in year 15 and the wife decides to add her child to the deed. Let’s further assume the wife dies in year 20 and the daughter wants to immediately sell the home. Because she acquired the property while her mother was still alive, her basis will be the same as her mother’s but because the home is not her primary residence, she will owe capital gains taxes on the $500,000 of appreciated value.
If her mother had recorded a revocable TOD deed, however, her daughter’s tax basis for the home would be the fair market value at time of her mother’s death- when she acquired the property. So, if she immediately sold the house, she would pay no capital gains taxes on the property also.
Keep in mind, the TOD deed must be revocable otherwise the beneficiary may have a vested interest while the original owner is still alive and deny her the step up basis.