How to Plan for the Inevitable: Inheriting Baby Boomer's Rental Properties

For years, baby boomers have enjoyed the status of the largest living adult generation, but that is poised to change in 2019 (Fry, 2018). Millennials are expected to overtake baby boomers, and others will likely follow. Baby boomers are making it into their late 50s, 60s, and early 70s, so it makes sense that it is time to pass the mantle to other generations.

How to Plan for the Inevitable: Inheriting Baby Boomer's Rental Properties

For years, baby boomers have enjoyed the status of the largest living adult generation, but that is poised to change in 2019 (Fry, 2018). Millennials are expected to overtake baby boomers, and others will likely follow. Baby boomers are making it into their late 50s, 60s, and early 70s, so it makes sense that it is time to pass the mantle to other generations.

If you are a baby boomer with rental property, it’s time to start thinking about the next step in life. What do you want to do with your rental property?

While you could sell it off, that would be a mistake. You’ve spent a great deal of time and energy building your rental property portfolio, and it can make money for generations. Instead of selling it, you can pass it onto your children. They can enjoy the benefits of a ready-made business, and you will have the peace of mind of knowing they will be taken care of well after you’re gone.

Of course, there is a lot to think about when giving your children your rental property. How should you go about the process? What can you do to make sure everything goes smoothly? How can you protect your children from taxes and infighting with their siblings?

Let’s begin by looking at the most common options for giving children rental property and then look over some other choices that might work better for your family. Then, you can make a plan to provide for your kids upon your death.

Wills and Living Trusts – The Most Common Option

Wills and Living Trusts – The Most Common Option

Wills and living trusts are extremely common when leaving children rental property (Wiewel, 2015). These are the easiest options, especially if you have an estate attorney take care of the process for you.

While many think wills and living trusts are essentially the same things, they are actually two very different documents that come with their own sorts of benefits and drawbacks.

Putting the Rental Property in Your Will – What You Need to Know

You can use an estate planning attorney to put the rental property in your will. When you pass away, the assets you’ve included will need to go through probate. This ensures the legal transfer of all the assets. In addition, the courts make sure that all debts are paid before the beneficiary receives the property.

If you leave your children property in a will, they will be taxed on the fair market value of the property when you die. Your children won’t be responsible for the appreciation (Intuit Turbo Tax, 2018). That makes this a smart choice for some families.

However, wills do have to go through probate, and that can be uncomfortable for families. The finances will become public record, and your children might be upset by that. That’s especially true if a family member feels slighted by what is in the will.

Also, if you own real estate in various jurisdictions, your family could have to travel to go to probate court. They could spend lots of time on the roads and in the courthouses, so by the time all is said and done, they might wish you hadn’t left them any property.

Putting the Property in a Revocable Living Trust

Putting the Property in a Revocable Living Trust

A living trust is a better choice if you want to leave your kids property. You’ll set up a trust, and then, you’ll fund it with your property. Funding the trust is simply the process of putting your assets, such as real estate, into the trust. When you are alive, the property is still essentially yours. You are in control of it, and you benefit from it.

As with any estate planning tactic, there are pros and cons to putting your real estate in a living trust (Pirraglia, 2018).

Pro – Avoid Probate

Probate is time-consuming and can be quite costly, as well. Your children will likely have to go to multiple hearings for the probate process, and that can be difficult, if not impossible. A living trust will allow you to avoid probate. This is especially important for those who own multiple rental properties in different jurisdictions. Your children will be very happy that they don’t have to travel from one location to the next just to get their hands on the property.

Pro – Protect Yourself if You Become Incapacitated

If you want to keep control of your rental property until you pass away, a living trust can help, even if you become incapacitated. If you are no longer able to manage the property, you can select a trustee to do so. You’ll still benefit from the properties, but you will not have to manage them. This can be important if you’re counting on the proceeds from the rental property to pay your bills.

Then, when you pass away, your property will transfer to your beneficiaries. At that point, they can start making money from it.

Pro – Ease Your Children into the Property Management Process

Many baby boomers look at living trusts as a way to ease their children into the property management process. You’ll still be in charge of the property while it’s in your trust, but your kids will have a vested interest. You can teach them the ropes while still reeling in the profits. This will make the handoff much easier.

Plus, when you set the property up in a trust, your kids will know exactly what to expect when you pass away, so they will be more invested in the business. They’ll see what’s coming in the future and realize they have to get involved now.

Con – Limited Tax Savings

There is a myth that a living trust has tax benefits, but that is not the case. The trust technically owns the property when you are alive, but the tax authorities still recognize you as the owner. You must report on the income and pay the proper taxes. When you pass away, the successor must pay all income taxes still owed upon your death. This could include state and federal inheritance taxes. If you’re concerned about taxes, you’re better off choosing a different method.

Con – It’s Complicated

Living trusts require lots of complicated documents, and they are expensive to set up and manage. If you have a lot of real estate holdings, management can become complicated. For instance, if you sell a property, you have to remove it from the trust. If you buy a new one, you have to add it to it. This means your legal expenses can add up. The longer the trust is active, the more expensive it will be, so keep that in mind before setting it up.

Con – Other Assets Still Subject to Probate

Many people put their real estate holdings in a living trust to avoid probate. However, if you have other assets, those assets might still have to go through probate. That means that while your family can avoid attending probate hearings for the real estate, they might still have to attend hearings for your other property.

Gifting the Property

Gifting the property is another option. While this is not a good choice for a primary residence, you can use it to sign over your rental property.

Before you gift property, you need to understand the annual and lifetime exclusions for gifts. The annual exclusion for 2018 and 2019 is $15,000 (IRS, n.d.). The lifetime exclusion is $11.8 million, but that doesn’t include the cost of gifts alone. It also includes the estate tax.

The lifetime exemption used to be $5.40 million, and the jump to $11.8 million is only locked in through 2025. It very well could go back down to $5.40 million after 2025, so if you’re interested in this option, you should consider doing it sooner rather than later. Otherwise, you could end up hitting the lifetime exemption before gifting all your properties.

If your home is worth more than $15,000, you will have to file a form with the IRS upon gifting it. However, you will not be taxed on this as long as you haven’t exceeded the lifetime gift limit.

Appreciation and Gifting – What You Need to Know

Gifting real estate does come with its drawbacks. If you give your children property as a gift, the tax basis will be the same for the children as it was for you. That means your children will be taxed on the amount the home appreciated during your lifetime.

This might seem unfair, but by giving it as a gift, you bypass selling it. You would have been taxed on the appreciation if you sold it, so now, your children will have to pay that tax.

Let’s look at an example of this to show you how it works.

Let’s say you have a rental property with a fair market value of $300,000 and a tax basis of $60,000. You gift it to your children, and they end up selling it for $310,000.

That means your children will make a gain of $250,000 on the home. To come to that figure, you simply take the $310,000 made on the sale and subtract the $60,000 tax basis.

Now, let’s say your children inherit the home when you pass away. The fair market value of the home is still $300,000, and the tax basis for your children will be $300,000, as well. Your children sell the real estate for $310,000, which is a gain of $10,000.

When you look at this example, you can see that your children would be on the hook for a hefty capital gains tax if you give the property as a gift.

Of course, your children won’t have to pay capital gains tax if they hold onto the property. It’s important to talk to your children about their plans before gifting them real estate. It could end up being a bigger burden than a blessing.

Selling Property to Kids – What You Need to Know

Some parents think they can get one over on the government by “selling” their rental property to their children. They believe this is a way to avoid gift taxes while passing the property onto their children.

It’s true that you can sell your property to your kids for any amount you want. If you want to sell it for a dollar, you can do just that, and then, your children will take legal ownership of the property.

Don’t think the IRS won’t notice, though.

Let’s say you sell a $100,000 property for a dollar. The IRS will likely look at it as a $1 sale and a $99,000 gift. That means it will still have the implications of a gift (Spencer, 2018).

Because it will be treated as a gift, it will be taxed as such.

Some people have learned this the hard way.

Nathan Zielonka, a financial planner in Newton, Massachusetts, remembers what happened when one of his clients purchased a home for $1 (Ashford, 2016). She’d lived with a man for 30 years, and although they weren’t married, she considered him her common-law husband. He didn’t have a will but wanted to take care of her after his passing, so he sold her the home for $1. Since the state didn’t recognize common-law marriages, she had to pay a whopping capital gains tax.

You don’t want that to happen to your children, so be incredibly careful when gifting real estate. Only do it if the property is going to stay in their possession. Otherwise, they will be hit with a huge capital gains tax.

Joint Ownership

You can cut down on the gift tax assessed by adding your children’s names to the deed to the property or properties you want to transfer. Your children will own 50 percent of the property, and if you fill out the right paperwork, it will pass directly to your kids after death. You can give your children the portion of the property as a gift, and while there are still some tax implications, the problems are minimal compared to gifting a full piece of property.

How Joint Ownership Property Is Taxed

Your children will have 50 percent ownership of the property, and that is considered a gift and will go against your lifetime gift tax exemption. When your half of the property is passed along to your children, it will be assessed with a stepped-up basis that is equal to the fair market value. Your children will combine the stepped-up basis with the basis of the property that was received as a gift. Then, your children will have the total adjusted basis (Block Advisors Tax Preparation, n.d.).

The total adjusted basis will be much more favorable than the basis for a property that is completely gifted. This will lower capital gains taxes considerably. If you are intent on gifting property to your children, this method is worth consideration.

How to Avoid Probate

How to Avoid Probate

Many baby boomers are turning to this method because it’s a way for them to avoid probate while still hanging onto the property. Unfortunately, though, some parents simply add their children’s names to their deeds, and when they pass, the kids have to go through probate anyway.

You need to create an entirely new deed with the rights of survivorship. Then, when you pass away, your children will receive the property without going through probate. It’s a good idea to have an estate planner handle this for you to ensure your children don’t have any issues when it’s time to take full ownership of the property.

Considerations

There are some things you need to think about before moving forward with joint ownership. First, your children will have 50 percent ownership of the property, and that means they will have 50 percent of the decision-making responsibilities. You won’t be able to refinance the mortgage or sell the property without your children’s permission. If you aren’t sure you want to hold onto a piece of property, this is the wrong choice for you.

You also need to be mindful of going this route if your children have credit issues. A tax lien or a creditor could make a claim against the property, even though your name is still on it.

In addition, your children’s ownership of the property could be in jeopardy if they get divorced. The former spouse could go after the property during the divorce proceedings, and then, you could end up with a new partner on your hands.

Speaking of new partners, your children will also have the right to sell their portion of the property to a third party. While this isn’t likely to happen, it does occur. That can be very frustrating for parents who want to leave something for their kids.

It’s important that you discuss the future with your children before putting their names on the deed. All owners of a property need to be on the same page to ensure everything goes smoothly. If everyone is on the same page and you don’t see any possible issues arising, you can move forward with this option.

Qualified Personal Residence Trust – A Good Option for Adding to Your Rental Portfolio

A qualified personal residence trust (QPRT) isn’t as common as some of the other strategies, but it might be a good option for at least some of your real estate holdings. While you can’t use a QPRT for all of your rental properties, you can use it for up to two homes, including the home you’re currently living in and a vacation home (FindLaw, n.d.). Each QPRT can hold a single property, so you will have to create a separate trust for both homes.

When you create this trust, you’re transferring ownership of the property to your children, but you can continue to live in the property. (Garber, 2018). You will set a specific amount of time for the trust, and during that time, you’ll get to live in the property rent-free.

At the same time, you will reduce the value of the gift you give your children. Your property won’t be worth the fair market value at the date of the transfer because your beneficiaries won’t have full ownership. The IRS will calculate the gift at a fraction of the price.

Various factors go into the calculation. The IRS will assess your age when the QPRT was set up and the interest rates you were paying at the time of the transfer. The IRS will also look at the number of years you intend to stay in the property.

The end result is a property that is valued well under the market value. It’s not unusual for a house with a market value of $650,000 to only take up $200,000 of your gift exemption.

Transferring the Property

Once the retained income period comes to an end, your beneficiaries will receive the property. You won’t own the property anymore, and that means the IRS cannot assess an estate tax against it.

You can rent the property at the end of the deal. Then, you can still live in your family or vacation home, and your children can put it up on the rental market after you pass away.

Many people look at this as a downside of setting up a QPRT, but that’s not the case. It’s actually a huge benefit. When you pay your kids rent, you can give them more of their inheritance without it going against your lifetime gift allowance.

What Happens if You Die Before the Retained Income Period?

If you pass away before the retained income period is up, it’s like the QPRT never happened. The home will become a part of your will if that was your wish, and it will have to pass through probate. That is why it’s important to put some thought into the retained income time period. You want to set it up properly, so your children can receive the property through the trust.

Using a QPRT as a Rental Property

It’s important to understand that your property cannot be used as a rental property while the QPRT agreement is in place. It must be a residence or vacation home. That means you cannot actually use existing rental properties for this purpose. However, you can use this method to expand your children’s rental portfolios.

This is a good choice if you want to pad your children’s investment portfolios. You can throw in your vacation home or residence (or both), so your children can make even more money off renters after you pass away.

Word of Warning – Splitting Property Between Heirs

With each of these strategies, you’ll have the option of leaving your property to a single person or to multiple heirs. If possible, have one owner per property. When multiple people inherit the same property, it can lead to a large number of problems.

When you leave a single piece of property to multiple heirs, they’ll have to decide if they want to continue renting it, live in it, or sell it after they inherit it. Even children that normally get along can argue about this, and there can be a great deal of confusion.

There are all kinds of horror stories about siblings trying to figure out what to do with inherited homes they share. In one case, one brother wanted to live in the inherited home, and the other did not and requested to be bought out (Wallis, 2015). The brother who wanted to live in the house was left struggling to find a way to take out a mortgage, while the one who wanted his cash was stuck waiting for his money.

This is actually one of the nicer stories about splitting property in wills. In some cases, siblings stop talking due to infighting. You don’t want your rental property to tear the family apart. So, divide the property up if you can.

Getting Your Children Prepared to Inherit Your Rental Portfolio

After you get everything in order, it’s important to prepare your children for what’s to come. The more your children know about what the future holds, the easier it will be for them to navigate the waters. If you do this correctly, they can hit the ground running with a successful real estate business.

Preparing for Taxes

Preparing for Taxes

You will do everything in your power to lessen the tax burden before handing the property over to your children. Still, there will be some taxes involved, so they need to be prepared. There are special tax consequences for renting a house they’ve inherited, so go over them with your kids now before it’s too late (Sherman, 2018).

Tax Breaks for Resident Homeowners – Off the Table

Inheriting rental property is a great opportunity, but it’s important for your kids to understand they won’t get the tax breaks that are available for resident homeowners. When your kids file their taxes, they won’t be able to get the same breaks they get for the homes they live in. Of course, they will get rental income, so it all works out in the end. It’s still a good idea for kids to understand that rental and residential properties are taxed differently.

Maximize the Deductions

Rental property might not get the same breaks at residential property does, but it still comes with some deductions. Let your kids know they can deduct basically everything they put into the property. If it still has a mortgage, they can deduct the interest. They can also deduct the money they spend on repairs and maintenance. Depreciation is even deductible.

If your kids take a hands-on approach to rental management, they can deduct even more. They’ll get to deduct the costs of vetting tenants, advertising vacancies, and other management duties. These deductions are not available if they hire a property management company.

Capital Gains Taxes and Rental Properties

As a landlord, you probably know a thing about capital gains taxes. Those three little words likely keep you up at night. You want to do everything you can to reduce capital gains taxes, and the same is true for your children.

You already know that you can reduce capital gains taxes by setting up a trust or adding your children to the deed instead of gifting 100 percent of the property, but your kids can also use some strategies to reduce the capital gains tax if they decide to sell the property (Marotta, 2014).

A 1031 exchange is the most common option for real estate investors. If your children sell the rental property, they just need to roll the proceeds into the same type of investment within 180 days. This is a great choice if your children want to continue working as a landlord.

Matching losses is another option. Your children can harvest capital losses and then use them to offset future taxes.

These are just a couple of the countless options. Encourage your children to work with a tax professional if they decide to sell the property. Also, remind your children that it’s easy to avoid capital gains taxes. If your kids hold onto the property and then pass it onto their kids upon death, they won’t have to pay any taxes on capital gains.

Real Estate Tax Reassessments

You also need to talk to your children about real estate tax reassessments. Property taxes are reassessed after the property changes hands. Some states provide an exemption for the reassessment, but you’ll need to look at the laws that govern your state to know how it’s going to be handled.

Rookie Mistakes Your Kids Need to Avoid

Going over the tax issues isn’t all you need to do. You also need to prepare your children to take over the family business. It might be in your blood, but until your children understand the nuts and bolts of it, they won’t know what to do. Go over some rookie mistakes with your kids, so they’ll be ready to manage the inherited property (Gengler, 2014).

Failing to Understand the Costs Associated with Being a Landlord

Your children surely see the big picture when it comes to being a landlord. They know they need to think about insurance and taxes, but what about repairs and upkeep? Managing rental properties requires cash on hand, and it’s important that your kids are prepared.

It’s important that your children understand they need to have an emergency fund in place to manage the property. Tell your kids to expect to spend up to 45 percent of the yearly rental income on costs associated with the property. Having a fund in place to cover that will come in handy, especially if the property is vacant for any period. Then, your kids will still have money in the account to advertise for the vacancy and maintain the property.

Failing to Understand the Laws

You might have rental properties in a single state, or you might have properties in multiple states. Go over the laws with your children that govern the properties in the states of ownership before they inherit them.

For instance, go over the notice the kids have to provide tenants before moving out. Some require 15 days for a month-to-month tenant, while others require longer. Go over all the laws ahead of time, so your children will be ready to take over the reins.

Failing to Properly Screen Tenants

You’ve likely had your fair share of bad tenants over the years. Every landlord has some horror stories to share. After renting to bad tenants, though, you realized you could avoid the problem by properly screening your tenants. Go over tenant screening procedures, such as background checks and credit checks, to save your children the trouble. Your children need to understand that quality tenants will make their jobs much easier and will help them earn a steady stream of income.

Failing to Keep an Eye on the Property

It’s important to regularly inspect a property. Have your kids put something in the rental agreement so they can inspect the property every six months. That way, they can look for leaky rain gutters and other issues that the tenant might not report. This will help your kids stay on top of repairs and will save them money in the long run.

Failing to Hire an Accountant

It doesn’t matter if your kids are going to inherit a single rental property or a full portfolio of them. It’s a good idea to use an accountant when tax time rolls around. Yes, they will have to pay for a professional’s services. However, an accountant can help them maximize their deductions and ensure they follow the tax code to the letter. That means they can avoid an audit if they use an accountant.

Failing to Hire an Accountant

It doesn’t matter if your kids are going to inherit a single rental property or a full portfolio of them. It’s a good idea to use an accountant when tax time rolls around. Yes, they will have to pay for a professional’s services. However, an accountant can help them maximize their deductions and ensure they follow the tax code to the letter. That means they can avoid an audit if they use an accountant.

Get Your Affairs in Order

Don’t wait any longer to get your affairs in order. You want to support your children well after you’re gone, and this will allow you to do that. Once your affairs are in order, talk to your kids about what to expect after inheriting the property. Then, your children can begin preparing for their future and you can enjoy your golden years, knowing you’ve provided for them.


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