Hi BiggerPockets. I'm looking for some advice regarding the transfer of property from my in-laws to their 3 adult daughters. I will, of course, seek advice from a legal/tax professional, but recall from time that I previously spent on this site that there are a lot of knowledgeable people who are willing to help.
The background: The house (located in Napa, CA) is owned outright by my wife's parents. They have poor credit, slightly below average income, little savings, and are nearing retirement (1-2 years). My father-in-law will have a decent pension. They will be moving to San Diego after retiring (possibly living with us) and will be renting their house out. Long-term, the plan is to hold onto the house and pass it on to their 3 daughters. They have mentioned setting up a trust to facilitate that, but have also said that they are open to other arrangements that would make better use of the property.
I wonder if it wouldn't be more beneficial to the family to create a multi-member LLC to hold the property. Rental income would flow through the LLC to my in-laws the same as if they retained personal ownership, but I think an LLC would allow flexibility in how the property is used for tax purposes. It seems to me that the 3 daughters would be able to realize some tax benefits through the LLC, whereas my in-laws would not be able to take full advantage on their own. Also, putting the home in a trust would prevent the daughters from potentially using the equity (not likely, but who knows?).
I'm sure there are many factors of which I am ignorant, and look forward to you setting me straight. Thanks for reading.
The professional response of course is consult with your CPA and Attorney.
The off-the-cuff response is I would have the parents setup a trust and transfer the deed to the trust. The parents can control the trust and set the rules for how the kids can access the trust.
I’m not aware of any tax advantages by structuring a SFR ownership as an LLC. I have a few LLC’s and rental property (not in a LLC). When I think LLC I think legal protection and the State of California’s $800 annual LLC fee that you will pay (that eats into your rental).
Is a LLC worth it? Not for a SFR IMO, but I am no expert. Consult with the pros!
You've raised a number of issues in your one short post. I don't know all the facts so I will refrain from giving any advice but will mention a couple of things. Do not take any of the following as legal advice and consult an attorney or other professional.
In California, an LLC will be subject to an $800 minimum tax, just for existing. The income from it will pass through and be picked up on the owners' individual income tax returns. It will be taxed at ordinary rates unless any of the owners qualify for the brand new 20% pass through rates which are rather complex. So the benefits to the LLC I could see are liability protection of course, multiple owners, and possible income tax advantages depending on the rate arbitrage of the owners.
You could put it in a trust but then the question becomes what kind of trust to create. The most common is probably your standard grantor/family/living trust. If your in-laws don't have an estate plan, they will likely want to create an estate plan if only for the sole reason of avoiding probate, which in CA can be a very expensive and long hassle, even if all parties get along amicably. Maybe their estate is under the threshold requiring probate, but if they continue to hold the property not in an LLC or other entity, they will likely want to create a family trust. Again, I don't know their circumstances so I will not give advice but suffice to say this is probably something you will want to look into. In the very least they should have wills (and probably health care directives, HIPAA documents, powers of attorney, etc.).
You can also create a trust that is a separate taxpaying entity such as a QPRT or gift trust. This might make good sense if the 3 kids plan to continue to operate the property as a rental after the in-laws die because a trust can have multiple owners and the trust document can govern various ownership percentages and rules for management and partitioning the property, etc. One of the downsides is that trusts hit the highest tax brackets rather quickly so if this property is producing profits, could be subject to tax at higher rates faster than if you created an LLC. The family trust if it is a grantor trust will be subject to tax on an individual income tax return at normal rates, not the accelerated trust rates. The higher trust tax rates are for separate tax-paying trusts which are usually irrevocable trusts.
You'll want to be cognizant in all of these options of the gift tax consequences of how the parents transfer ownership and when they do so. Sounds like the in-laws aren't entirely wealthy that they may not owe actual gift tax but they could create a filing obligation. You can also consider a sale to the daughters.
There are two other major considerations that I don't know if you've thought about though and those are capital gains taxes and property taxes. Without getting into too much detail, the rule is sort of like this: when you sell property, you take the money you sell it for and subtract your basis to get a net gain (or loss). Your basis though, has a major difference between whether you are gifted the property or whether you inherit the property. You didn't give details about when the parents bought the house or how much its worth, but if they bought the property a long time ago for a low price, then they have a low basis. If they gift the property, the recipient takes a "carry over" basis meaning they also get the parents' basis. If, however, the kids inherit the property, they take a "stepped up" basis or "step up in basis" and their basis becomes the fair market value on the date of death. So.... say, parents bought the property 15 years ago for $200k. It's worth $400k now. They die 5 years from now and it's worth $600k. You sell the property another 5 years after that for $800k. If they GIFT the property, you get their basis of $200k, so you will pay capital gains on $600k (800-200). If you INHERIT the property, you get a basis as of the fair market value as of the date of their death and you pay capital gains on $200k (800-600). Could potentially be a huge difference there that you want to consider. If you do not plan to keep the property in your family after the in laws die, could possibly be no gain if you sell it for its fair market value (worth 600k when they die, take a stepped up basis of 600k, sell it soon after death for FMV of 600k, equals no gain).
The other major consideration sort of relates to the basis issue is with property taxes. If the parents bought the property a long time ago for a low dollar amount, it likely is assessed at a relatively low value in comparison to its actual fair market value. Once the property goes through a change of ownership such as placing it into an LLC if the owners are different or inheriting it or gifting it, the property could potentially be reassessed to current fair market value, and property taxes will be based on that new, probably higher, value of the property. Can maybe use a parent-child exclusion but I believe this option would be lost if the property is in an LLC. A parent-child exclusion stops the property from being reassessed if the transfer is from a parent to child but I think this cannot be done if the property is in an LLC since at death the child would receive an LLC interest and not the property itself, since the LLC is the owner of the property. So.... if they bought the house only a few years ago, then maybe not a big deal, but if they bought it a long time ago and it has a low assessed value, this could mean major dollars in terms of property taxes every year, which is often overlooked.
Hope that's some food for thought. I'm sure I've missed several things but you raised a ton of issues in your one short post.
Again, I do NOT have all the facts here so none of the above is intended to be legal or professional advice. This post and information does not create an attorney-client or CPA-client relationship.
@Steven Straughn Katie mentioned many good points.
I can confirm (from personal experience with similar situation) that you'll be able to add the daughters onto title (using the parent-child exclusion) without triggering a re-assessment and presumably much higher property taxes. Unless there's more to the story your pro knows that we don't. ;)
Now, onto some thoughts that may or may not be helpful when you talk to your pro...
1. Hopefully her parents will have many more years of health and happiness. In that case, from a tax perspective, it'd be great if the parents captured the income from the property and the daughters captured as much of the depreciation and write-offs as possible. Too many variables to advise here, but you may want to discuss with your pro.
2. Financially speaking, the family may be far better off turning the home into cash and investing that cash today (depends on value of property, potential rent, and area it's in). The in-laws still have their primary residence exclusion, so that sale may be tax free (or largely tax free) for them if they do it now. Also, note the house will only deteriorate once tenants start moving in and out over the years ... given the market today and presumably good condition of the home right now, I would at least consider selling now and investing proceeds for income the in-laws can live off of now.
3. Gonna be hard for your in-laws to access the equity once they retire. In a pinch, I suppose putting it in an LLC would make it easier to access the equity from an HML.
4. Other than that, I can't think of a scenario where it makes sense to put this into an LLC. The $800 annual fee and filing requirements is a pain. Insurance on the place will cover most anything that could happen from a protection perspective. You can handle control by using a trust (which they probably need anyways).
Good luck - I applaud that you're thinking through all the details in an attempt to optimize this for the family!
A lot of the decision will depend on when the folks bought the property and for how much vs what it's worth today.
They are sitting on a tax-free gain most likely if they sell now or at least within 3 years of renting it out.
If heirs are put on title or given ownership prior to death, the heirs receive the cost basis the parents bought at. Maybe not a big deal if bought last week or in '08, but a killer if they bought in 1962 for $6200.
@Steven Straughn - what was the purchase price vs current value? How long ago did they buy it??
I agree strongly with points #2 (sell and take the tax-free gain) and #4 (what the heck would an LLC do for you but cost money and indigestion?) made by @Justin R.
Over-sophisticating little houses is usually trouble. Sell and let them do what they want with the money, like invest locally or buy the heirs an annuity or something.
The only logical choice I see would be be to sell the property and liquidate or lose the capital gain tax exemption. Additionally the return on a single family rental in Napa on a value to rent ratio would be dismal.
It is hard to write anything helpful after the incredible answer from @Katie Lepore (thumbs up, colleague!) - but I'll try.
I think it would be easier to make decisions once you separate various issues that you threw together. Listed in what I consider the proper sequence of decision-making.
1. Unrelated to your questions, but I must mention it. Do you really want to live with your in-laws? Having siblings makes it even more complex to decide.
2. Are they moving to San Diego after retirement? You said yes, but just make sure that this answer is firm. Because if it's just a maybe, then it also may be too early to be making any moves. Keep in mind that even their firm decision may change between now and retirement - health, family dynamics, economy and whatnot. If it was me, I'd wait until they retire, just because of the uncertainty.
3. Assuming they do move, does your entire family want to keep the house? Economic reasons (viability of renting, past and future appreciation, alternative opportunities to invest etc.), sentimental reasons, backup option to move back reason and many other possible reasons, but NOT including taxes. Taxes have to be specifically ignored at this step.
4. If in the previous step you conclude that holding on to the house is optional - then sell as soon as they move out. The reason is not taxes, although tax-wise it would be great, too. The reason is family dynamics. Four families and one house = time bomb. No matter how close-knit your family is, this thing one day will create tension. Not if, but when. I have 20 years in this business and hundreds of clients to back up my conviction. Deny it at your own risk. (Ditto for my #1, by the way.)
5. If you all decide to keep the house, for whatever NON-tax reasons (great investment, parents might want to return, you might want to move there one day, etc.) - then the next decision is whether to shift ownership to the daughters while the parents are alive. Important: we're not talking yet about how to structure it and whether to keep parents as part-owners. It is simply this: do we initiate the transfer (full or partial - does not matter yet) now - or do we wait for inheritance transfer.
There were plenty of important factors mentioned before me, but I believe there are 3 deciding factors (and they are conveniently contradicting):
- family dynamics - i.e. will you accidentally open the pandora box (yes, I know plenty of crazy stories, always along the lines of "who could expect this?", including parents kicked out by kids, siblings becoming enemies and a lot more)
- step-up tax basis - see the excellent explanation by @Katie Lepore
- qualifying for Medicaid or any other government help. I don't think anybody brought this up yet, but there're situations when parents may want to get rid of property ownership, despite the tax disadvantages
6. Only now is the time to think about structuring: LLCs, trusts, and whatnot. Also 100% to the daughters or still under parents control. It will depend on what you decide on the previous step and will need to be discussed with a California-licensed family attorney. NO taxes considered here!
7. The last step is the tax implications. Only AFTER everything else has been considered and decided.
Enjoy the process!
There are some great ideas and posts on here, which can certainly be applicable to this situation. I am going to throw out another, perhaps more complicated, idea: a combination Section 121 exclusion (generally for a residence lived in for two of the last five years) and a 1031 exchange for the remainder of the gain. This will allow your in-laws to potentially get up to $500,000 of the house gain without taxes and then to exchange the remainder of the gain into another investment property. This plan requires some planning, but can be a great option. I previously wrote an article on this strategy posted here: https://www.linkedin.com/pulse/once-delaying-may-your-best-option-bryan-zuetel.