“[B]ut in this world, nothing can be said to be certain, except death and taxes.”
When it comes to your home, death and taxes go together but these days, probably not in the way you think. Estate taxes are no longer relevant to most people. But other taxes, namely income and property taxes, can significantly affect the value your heirs get out of your home. Probate can have a significant effect too. We’ll discuss why estate taxes are unlikely to matter and then discuss how the other factors might affect the value for your heirs and what you might do as a result.
1) Estate Taxes
The federal government taxes what you own when you die (California does not although legislation was introduced this year to reinstate a California estate and gift tax, which even if passed would require a vote by the people to become law), which is known as the estate and gift tax and it is substantial: 40%. But for most people, estate taxes are not a consideration, even with home values in Marin, because the federal estate tax exempts a very large value of any estate from the tax. The Trump tax changes in 2017 raised the amount exempt from federal estate tax to over $11 million per person and if you are married, the law allows you to make use of your spouse’s exemption too (if you take the right steps after he or she dies.)
The Trump tax changes for individuals are scheduled to expire in 2026 and if that happens without Congress taking any action before then (Congress could extend the changes or abolish them or otherwise change the rules entirely), the exemption will drop back to what it was before: about $5.5 million, which is still more than what most people will have, even with a house in Marin.
If the value of your home and everything else you own might approach even this lower number, then you do need to think about estate taxes and you should consult an estate planning lawyer about planning for them. Today’s information is for those who won’t be affected by estate taxes. But one important point for everyone: even if you put your home into a standard revocable living trust, it is still subject to estate tax. Living trusts can be a way to save on estate taxes but simply putting something into a trust doesn’t mean that it is not subject to estate tax.
a) What it is. When you die, your stuff has to go somewhere. As they say, “You can’t take it with you.” Okay, “stuff” isn’t exactly a technical term. Traditionally, your will tells people who gets what. And that “what” includes not just what we think of as stuff—like your car or your couch or your one-of-a-kind Bob Dylan vinyl demo—but your bank accounts and your .2 house too. Someone is supposed to file your will with a court and the court supervises how everything gets distributed as well as how it is valued. If you die without a will, this is called dying “intestate” and California’s laws set out who gets your stuff. A court is supposed to supervise this process too. With or without a will, this court-supervised process is called “probate.”
b) Why it’s bad. So what’s the big deal? There are three main disadvantages of having to go through probate. The main one to most people is that it costs a lot of money. The cost is based on a percentage of the value of your stuff. It’s 4% for the first $100,000, 3% of the next $100,000, then 2% up to a million, then 1% and then less after ten million. If you have a $1 million home, no matter what the mortgage might be, that’s $25,000 plus court costs just for an attorney. And technically, an attorney can charge more for “extraordinary” work and the executor (the person named in the will to handle the estate) gets to charge the same fee as the attorney. Often an executor is a family member or friend who will waive their own fee but still….
What are the other two main disadvantages? The process is slow and tedious and so your estate won’t be settled for a long time. It’s also public. Many people don’t really care about that but most court documents are public documents and so people can find out details about your estate.
c) Avoiding Probate: Living trusts. What can you do about this? Now that estate taxes are not a consideration for most people, avoiding probate is the main reason that people create living trusts. Anything you put into a trust does not go through probate. Instead, whomever you appoint to be trustee after you’re dead will supervise the administration of your estate, or at least what’s in the trust. Often, the trustee is the same person, or one of them, who is going to inherit. A trustee may still need to hire a lawyer to help and some trustees are paid. But this, along with the cost of setting up the trust, usually costs less than probate.
d) Avoiding Probate: Transfer-on-Death Deeds. Living trusts aren’t the only way to avoid probate. Starting in 2016, California has a revocable transfer-on-death deed for real property with one to four residential units, condominiums or certain residential agricultural land. As of now, this option goes away in 2021 but deeds that were done before then will still be valid. A committee is studying how transfer-on-death deeds are being used (one fear was they might make it too easy to pressure an elder into changing who gets their home) and there is a good chance that the Legislature will make this a permanent option before 2021.
The transfer-on-death deed can be a great option for many people. You can change your mind and revoke it fairly easily. Or if you sell your home before you die, the deed becomes irrelevant and you don’t have to do anything extra when you sell. It’s fairly simple to complete a form to create the deed. Probably the trickiest part is making sure that you have the full legal description of your property correct. I recommend consulting a lawyer but it is certainly possible to do yourself. Once you complete the deed, you must record it with the county recorder’s office within 60 days of signing it. That will cost about $100 and is straightforward but if “county recorder” intimidates you, a lawyer can do it as part of completing the deed for you.
There are some limitations though. You can leave your property to multiple people, such as your three children, but it must be in equal shares. Particularly if you have given one child (or other heir) a large gift before you die, you can’t give her a smaller share of your home with this deed. You also have to name the specific individuals. You can’t fill out the deed when you’re young and say “to my children,” thinking that once you have children, they will inherit it equally. And a significant limitation for some people is that if you are leaving your home to your children, the deed will not allow one child to buy out the other’s share and still keep your property tax basis (which we’ll talk about more below.) It also doesn’t work for property held in joint tenancy or as community property with right of survivorship. And as of now, you cannot leave property to charity this way (there are efforts to change that, which may be successful if the law is renewed.)
As an aside, many things besides your home can be automatically transferred on death. For some financial accounts, you can designate a beneficiary to receive the account when you die. These are called pay-on-death or transfer-on-death accounts. As a general rule, things that have named beneficiaries do not go through probate.
e) Avoiding Probate: Joint ownership. If you own your home as “joint tenants” or “in joint tenancy” (which are legally the same thing), then when one owner dies, the remaining joint owner or owners automatically become the current owners. Legally, it’s instantaneous but not surprisingly, you still have to fill out paperwork to update your deed. The property does not go through probate. You’ll also hear or see the term “joint tenant with right of survivorship.” In California, all joint tenants have the “right of survivorship,” which means that joint tenancy works as set out above: the property passes automatically to the other joint tenants. If you own real property as a joint tenant, what you say in your will does not affect that property: it passes directly to the joint owners even if you say in your will that you leave everything to your son.
As another aside, you can also own financial accounts jointly and they will pass without going through probate as well. The difference between pay-on-death accounts is that all joint account holders have current access to the account. Many spouses in California own property as joint tenants, in part because many years ago they were told that was the best thing to do. It’s not. There are many downsides to owning property jointly. Some of them have to do with taxes, which we’ll talk about in the next section. Perhaps the most obvious issue is that unless you add new joint owners (which is not as straightforward as you might think), eventually everyone will die and the last owner will own it by herself and when she dies, it will go through probate. So if you own property jointly with your spouse, you might think it’s convenient when your spouse dies. In one way it is but then you own it by yourself and you’re not avoiding probate that way. And in general, the tax consequences are bad for spouses owning property jointly, which we’ll talk about more below.
Another major disadvantage of joint ownership is that the property is subject to the creditors of all the owners. If, say, one owner is at fault in a bad car accident and is underinsured, a creditor can force a sale of your property. This is often reason enough for most people not to put their children as joint tenants. A joint tenant can also sever (i.e., end) the joint tenancy without telling anyone, sometimes even unwittingly himself. If someone does that, that joint owner becomes a “tenant in common.” The difference from joint tenants is the right of survivorship: there is none. Unlike with joint tenants, with tenants in common, an owner’s share can be sold separately and passes via that owner’s will, i.e., through probate. A joint tenant severing the joint tenancy has led to numerous court cases because it can radically alter what people expect to happen to the property.
3) Income Taxes
When you sell your house, the increased value of your house over what you paid for it (what you paid for it, after adding money you’ve put into the house in improvements, is called your “cost basis”) is considered to be income and you have to pay income tax on this amount. The profits from the sale of assets that appreciate, whether a house, stocks, art, are called “capital gains” and are taxed at special rates that are different from other income. (Unfortunately, if the value of your home has gone down and you have a loss when you sell it, that loss is not deductible on your taxes. Losses from “personal use” property, such as your home, as opposed to investment property, like stocks or a rental home, are not deductible.)
Capital gains tax is where one of the few “benefits” of death exists: when you die, you don’t (or more accurately, your estate doesn’t) pay capital gains taxes on property that your estate sells, no matter how much more valuable it is than when you bought it. And if your estate doesn’t sell the property, your heirs inherit it with this new cost basis that is “stepped up” (or down) to its value when you died. So if your heirs later sell the property, it’s as if they bought it when you died and they will owe capital gains tax only on any appreciation in value after that.
In other words, if you sold your house the day before you died, you would owe capital gains tax on the gain from the sale. The same is true of everything else you own, like stocks, collectibles, art—anything that increases in value. But if your heirs sell your house the day after you die, they will not pay capital gains tax because their cost basis for your house (or stock or art, etc.) is its value when you died.
The other key thing to know about capital gains tax is that if you give a gift to someone of an asset like stock or a house while you are alive, the person receiving the gift gets your cost basis with it. So if you give someone 100 shares of stock worth $15,000 but you’ve held the stock for years and paid say, $1,000 for it, you are giving your giftee less than $15,000 because they will have to pay capital gains tax on $14,000 if they sell it.
So if capital gains tax “goes away” when you die, why do you need to know about it? It’s because there is such a difference in the amount of tax you pay between keeping something until you die and selling it before you die that it’s important to know about it. There are of course many other factors that affect why you might or might not sell your home before you die, but it’s important to be aware that selling before you die could lead to paying lots of taxes and reducing what your heirs will get.
a) Principal Residence Exclusion. If you need or want to sell your home before you die, there are still a couple of things you might be able to take advantage of to reduce your taxes. You are probably aware that there is some sort of special tax treatment if you sell your principal residence. You are allowed to exclude $250,000 of capital gains from both federal and California tax when you sell your principal residence or $500,000 if you are married and file a joint tax return. For many people, that will not exclude all of the gain in value of their home but it certainly helps.
There are many complicated details to this exclusion but the main requirement is that for something to be your principal residence, you must have lived in it for two out of the previous five years. That rule is relaxed for some people, like members of the military. And one detail of the rule that many people don’t know about is that if you are widowed, you can still take both your and your deceased spouse’s exclusions (assuming you otherwise meet the requirements) up to two years after your spouse dies. Aside from asking your accountant, IRS publication 523 is a good place to learn about all the details. (The IRS regularly updates publication 523; as of today, the latest version was published December 21, 2018. You can get a copy of it at: https://www.irs.gov/pub/irs-pdf/p523.pdf.)
b) Joint Ownership and Capital Gains. A discussion of the tax consequences of joint ownership is fraught with complications and beyond our scope here. But there are some very clear consequences that are important. Most notable is the effect of joint ownership by spouses. In most cases, if spouses are joint tenants, when the first one dies, only the deceased spouse’s half of the house will get a stepped-up basis to the fair market value at time of death. (If you bought your home before 1977, as a recent client of mine had, the non-spouse rules apply.) But if you own your home as community property with right of survivorship, the cost basis of the entire house is stepped up when the first spouse dies. That can be a big difference and as mentioned above, this is another reason, at least for spouses, not to own their home as joint tenants. For joint owners who are not spouses, the general rule is that capital gains and any step up in basis are based on how much each owner contributed.
4) Property Taxes
As all homeowners know, you have to pay property tax on your home every year. Property taxes are based on how much the county assessor thinks your home is worth. You pay a percentage, usually a little over 1%, of this “assessed value” every year. And as most Californians know, we passed the famous Prop 13 in 1978, which limits how much the assessed value of your home can rise each year to 2%. Because property values in California have gone up in the long term much more than 2% per year, the longer you have owned your home, the bigger difference between your assessed value and the current fair market value of your home. And that means that the longer you own your home, the lower your property taxes are compared to someone who just bought one. For many long-term homeowners in Marin, the difference is many, many thousands of dollars per year.
a) The Parent-Child Exclusion. Why would you care about property taxes after you’re dead? Of course, you won’t, but your heirs might. That’s because in 1986, Californians passed Prop 58, which allows children to inherit their parents’ assessed value along with the property itself. If your children are going to sell the property right away, this exclusion doesn’t matter all that much (although could still save thousands in some cases just in the time they own it before sale.) But if they keep it, it can be of enormous value. And you actually don’t have to be dead either. The exclusion applies to gifts or sales while you’re alive as well.
You don’t necessarily have to do anything to enable this (but see the last paragraph of this section) but at a minimum, your children have to file paperwork with the county assessor. They have three years from the time you die (or a gift is made) to do this and still have the lower property tax be retroactive to the date of death. They can still do it even after three years but they won’t get a refund for any taxes they’ve already paid. But who wants to pay out thousands of dollars more even temporarily? They should file no later than when they move the property into their names.
The exclusion allows children to inherit the assessed value of your primary residence with no limit on its value. And it allows them to inherit up to $1 million of additional property (per transferor) and keep its assessed value. That $1 million is the property’s assessed value, not its current fair market value. (In other words, if your vacation home is worth $2 million but you bought it 40 years ago for $100,000 and the county assesses it at $200,000 today because of Prop 13’s limitations, giving that property to your child uses up only $200,000 of your $1 million.) The exclusion also applies to transfers to grandchildren when the parents are dead. In general, step-children qualify and spouses of children as well. Critically, the exclusion is available when you own the property personally or in trust but not if you own it through any sort of legal entity like a partnership or corporation.
When you have multiple children and/or multiple properties, things can get tricky. It is possible for one child to inherit a property and your assessed value along with it and have other children inherit other assets. But you should consult a lawyer because what you say in your will or trust affects the power to make this happen. It is fairly easy to mess up and have a property (or more likely, a portion of it) be considered a sibling-to-sibling transfer and get reappraised. For example, if you use a transfer-on-death deed to leave your house to your two children and one wants to live there, if that child bought her sibling’s half, that half would get reassessed to the current fair market value.)
b) The Downsizing Transfer. When you sell your principal residence and downsize by purchasing another property, you may be able to take your property tax basis with you. You (or your spouse if married and residing together) must be 55 years old or older. You must buy a new principal residence (defined for both sold and purchased properties as eligible for the property tax homeowner’s exemption) of equal or lesser value within two years of selling. This option is available only once in your life.
You can then pass on that low property tax basis to your children. You cannot, however, give or sell your principal residence to your child along with its property tax basis and take that basis to your new replacement property—it’s one or the other. And you are also limited to where that replacement residence can be. It can be anywhere in the same county as the one you’re selling but only about 10 counties allow you to bring a property tax basis from another county. Three of those are in the Bay Area: San Mateo, Santa Clara and Alameda. Last November, California voters rejected a ballot measure that would have allowed taking your property tax basis to any county, along with other favorable changes. And there are continuing efforts to repeal the existing benefit but it is impossible to say just how likely they are to be successful but there is a not insignificant chance they will be.
A few of the important take-aways from all of the above:
Probate is expensive and if you own a home, you likely either should put it in a trust or complete a transfer-on-death deed.
In general, avoid joint ownership. If you are married and are joint tenants and don’t plan to put property into a trust, you should change your ownership to community property with right of survivorship.
Consider the capital gains consequences when you are deciding what to do with your home and if you sell, make sure you take advantage of the principal residence exclusion when you can.
Keep in mind potential property tax benefits when planning your estate or planning a move and make sure you plan appropriately to take advantage of them when available.
Rob Rosborough is a family-conflict mediator and estate planning lawyer with Monty White LLP here in San Rafael. He also mediates and advises on homeowners association matters as well as small business issues. He is Secretary of the board of the Marin County Bar Association (and will be President in a couple of years) and is Editor of The Marin Lawyer. He is also a professor at USF’s Fromm Institute and a meditation teacher at the Integral Yoga Institute in San Francisco. He is a graduate of Yale and Stanford Law School.
As with anything related to the law, these are generalizations and there are numerous exceptions, qualifications, exemptions and further details to virtually every statement made here. You should make sure you know about them before acting or relying on anything here, and the most reliable way to do that is to consult a tax professional or lawyer—or both. And the law is constantly changing.