Q: Is it foolish of me to have my daughter listed as co-owner of my condo? She and I are both on the deed. I've read that her name should be taken off so that the condo will be an inheritance, for tax purposes, when I pass away. -- PE, via email
A: It sounds as if you're the only one who lives in the condo even though your daughter is also on the deed. If that's the case, she'll get the full benefit of inheritance tax treatment at your death.
The tax law applies differently to different situations. Here are four scenarios:
In Scenario One, your daughter isn't on the deed. In that case, she inherits the condo at its market value at the time of your death -- or, in tax jargon, she gets a 'stepped-up' cost basis. When you sell a condo, your taxable profit is the sale price minus your cost basis. So if the condo is worth $250,000 when your daughter inherits it, her cost basis -- 'stepped-up' to its market value -- is also $250,000. If she sells the condo for $250,000, her taxable profit is... zero!
In Scenario Two, you and your daughter are both on the deed and both live in the condo. At your death, she inherits your half, on which she gets a 'stepped-up' cost basis. The condo's worth $250,000, so she gets a $125,000 cost basis on half its value. But her cost basis on the half she already owns is half of the condo's original cost. If you originally bought it for $100,000, her cost basis on her half is $50,000. Her total cost basis is therefore $175,000 --$125,000 (on your half) plus $50,000 (on her half). If she sells the condo for $250,000, her taxable profit will be $75,000.
In Scenario Three, you give the condo to your daughter for Christmas. (You'll move into a new condo down the street.) Your daughter has received the condo as a gift during your lifetime, and therefore she also gets your original cost basis. When she sells the condo for $250,000, her cost basis is the $100,000 you originally paid for it. Her taxable profit: $150,000.
Clear so far? Then let's move on to your actual situation, which we'll call Scenario Four.
In Scenario Four, your daughter is on the deed with you but she doesn't live in the condo and won't inherit it until your death. This is a common arrangement between parents and adult children. The legal jargon for Scenario Four is that you have retained a 'life estate' in the condo. Translation: It's understood between you that you'll spend the rest of your life there, and she'll get it after you die.
There's nothing in writing, you say? It doesn't matter. The IRS takes the position that when this arrangement is between a parent and a child, the mere fact that the parent continues to live in the condo implies the existence of a retained life estate, even if there's nothing in writing.
The IRS gives Scenario Four the same tax treatment as Scenario One: At your death, your daughter will inherit the condo at its full 'stepped-up' market value. (UPDATE: Since I wrote this post in November 2009, Congress has let the federal estate tax expire. The result: if you who inherit under Scenario Four from someone who died after January 1, 2010, you won't get a step-up to market value. However, that caveat is temporary. As soon as Congress passes a new federal estate tax law -- which it is expected to do this year -- people who inherit property in which the decedent retained a life estate will once again inherit it at its market value.)
Whenever I write about this, I get letters of protest from readers saying that their tax accountant insists Scenario Four is a lifetime transfer and therefore gets the same tax treatment as Scenario Three.
So here are the pertinent citations from the Internal Revenue Code:
Section 2036 of the Internal Revenue Code says that when you retain a life estate in your house, 100% of its value is included in your taxable estate when you die. And Section 1014 of the Internal Revenue Code says that your heirs get a 'stepped-up' cost basis on everything that is included in your taxable estate when you die, with a few exceptions ... which do not include a retained life estate. Therefore, your heirs get the step-up on a house (or condo) in which you had a retained life estate.
Indeed, the Scenario Four tax treatment has historically applied even if you move out of the condo before you die. For example, in a 1969 case, `Linderme Estate vs IRS', the court ruled that a retained life estate was still valid despite the fact that the decedent had vacated the property 19 months before he died to enter a nursing home.
A: It sounds as if you're the only one who lives in the condo even though your daughter is also on the deed. If that's the case, she'll get the full benefit of inheritance tax treatment at your death.
The tax law applies differently to different situations. Here are four scenarios:
In Scenario One, your daughter isn't on the deed. In that case, she inherits the condo at its market value at the time of your death -- or, in tax jargon, she gets a 'stepped-up' cost basis. When you sell a condo, your taxable profit is the sale price minus your cost basis. So if the condo is worth $250,000 when your daughter inherits it, her cost basis -- 'stepped-up' to its market value -- is also $250,000. If she sells the condo for $250,000, her taxable profit is... zero!
In Scenario Two, you and your daughter are both on the deed and both live in the condo. At your death, she inherits your half, on which she gets a 'stepped-up' cost basis. The condo's worth $250,000, so she gets a $125,000 cost basis on half its value. But her cost basis on the half she already owns is half of the condo's original cost. If you originally bought it for $100,000, her cost basis on her half is $50,000. Her total cost basis is therefore $175,000 --$125,000 (on your half) plus $50,000 (on her half). If she sells the condo for $250,000, her taxable profit will be $75,000.
In Scenario Three, you give the condo to your daughter for Christmas. (You'll move into a new condo down the street.) Your daughter has received the condo as a gift during your lifetime, and therefore she also gets your original cost basis. When she sells the condo for $250,000, her cost basis is the $100,000 you originally paid for it. Her taxable profit: $150,000.
Clear so far? Then let's move on to your actual situation, which we'll call Scenario Four.
In Scenario Four, your daughter is on the deed with you but she doesn't live in the condo and won't inherit it until your death. This is a common arrangement between parents and adult children. The legal jargon for Scenario Four is that you have retained a 'life estate' in the condo. Translation: It's understood between you that you'll spend the rest of your life there, and she'll get it after you die.
There's nothing in writing, you say? It doesn't matter. The IRS takes the position that when this arrangement is between a parent and a child, the mere fact that the parent continues to live in the condo implies the existence of a retained life estate, even if there's nothing in writing.
The IRS gives Scenario Four the same tax treatment as Scenario One: At your death, your daughter will inherit the condo at its full 'stepped-up' market value. (UPDATE: Since I wrote this post in November 2009, Congress has let the federal estate tax expire. The result: if you who inherit under Scenario Four from someone who died after January 1, 2010, you won't get a step-up to market value. However, that caveat is temporary. As soon as Congress passes a new federal estate tax law -- which it is expected to do this year -- people who inherit property in which the decedent retained a life estate will once again inherit it at its market value.)
Whenever I write about this, I get letters of protest from readers saying that their tax accountant insists Scenario Four is a lifetime transfer and therefore gets the same tax treatment as Scenario Three.
So here are the pertinent citations from the Internal Revenue Code:
Section 2036 of the Internal Revenue Code says that when you retain a life estate in your house, 100% of its value is included in your taxable estate when you die. And Section 1014 of the Internal Revenue Code says that your heirs get a 'stepped-up' cost basis on everything that is included in your taxable estate when you die, with a few exceptions ... which do not include a retained life estate. Therefore, your heirs get the step-up on a house (or condo) in which you had a retained life estate.
Indeed, the Scenario Four tax treatment has historically applied even if you move out of the condo before you die. For example, in a 1969 case, `Linderme Estate vs IRS', the court ruled that a retained life estate was still valid despite the fact that the decedent had vacated the property 19 months before he died to enter a nursing home.
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.
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