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Experts report that 70% of all Americans have no written estate plan. And, of those who have planned, most have created a simple will or rely on joint tenancy ownership of their assets to distribute their estate. Unfortunately, for the majority who have no plan in place, state law will dictate how their estate is to be distributed at death.

Probate

"The court-supervised process by which a will is determined to be the will-maker's final statement regarding how the will-maker wants his or her property distributed. It also confirms the appointment of the personal representative of the estate. Probate also means the process by which assets are gathered; applied to pay debts, taxes, and expenses of administration; and distributed to those designated as beneficiaries in the will."
(source www.munley.com/legal_glossary_p.htm)

Avoiding probate is an appropriate goal. Unfortunately, as with everything else we’ve learned, there’s a right way and a wrong way to do it. The wrong way could cost you thousands.

The Wrong Way

Avoiding probate is simple: Just title all your assets jointly with your spouse. This works fine, provided (a) you have a spouse, and (b) your combined estate is below $1,500,000. But if either (a) or (b) is not true, holding assets jointly with another person is a terrible solution, for while it avoids probate, it creates another — very expensive — problem. Let’s see how this often happens:

Mom, a widow, owns one major asset, a house worth $180,000. She wants her only daughter Ann to inherit it.

Ann and her mom know about probate all too well, having gone through it when Ann’s father died a few years ago. Mom is getting up in years, and she wants Ann to avoid probate on Mom’s estate. 

Mom thinks Ann can avoid probate by having Ann become a joint owner of the home, along with Mom. Therefore, Mom retitles the house from her name only to joint ownership with Ann.

This indeed enables them to avoid probate. But as I’ve stressed, probate is an administrative matter, not a tax matter. So this is where it gets interesting.

Since Mom’s estate is below $1,500,000, she knows no estate taxes will be due at her death.

She’s right. But in one of the nastiest tricks of the tax code, Mom and Ann are fooled into thinking they do not have to worry about taxes at all, when in fact they merely do not have to worry about estate taxes. Since Mom’s estate is below $1,500,000, they are right that Mom’s estate will not incur an estate tax, but they have forgotten about the capital gains tax.

Mom bought the house 40 years ago for $30,000. It is now worth $180,000. 

Tax law says that if you sell an asset for more than you paid for it, you must pay taxes on the profit (the capital gain), which in this case is $150,000. If Mom had remained sole owner, leaving the house to Ann via her will, Ann would have received the house as an heir via the (dreaded) probate court.

But that’s not what they did. To avoid probate, they put Ann’s name on the deed of the house along with her mother. Ann, no longer an heir, is now an owner. And tax law treats owners very differently than heirs.

If Mom remained sole owner, Ann would have inherited the house at its current value of $180,000 (the stepped-up basis), meaning she’d be able to sell it without incurring any capital gain and thus with no capital gains tax. But as an owner, she inherited the house with Mom’s original cost basis of $30,000 intact. As a result, when Ann sells the house, the $150,000 profit will be subject to capital gains taxes. In other words, while Ann has avoided probate and does not incur any estate tax, she could have to pay federal capital gains taxes of as much as $22,500. That’s a pretty stiff cost to avoid probate.

Five More Reasons Not to Title Assets Between Generations

If Mom and Ann’s story isn’t enough to stop you from titling assets between generations — or, frankly, with anyone other than your spouse — following are more horror stories for you to consider. Remember: These pitfalls apply to all kinds of assets — mutual funds, stocks, bonds, and bank accounts — not just real estate.

Reason #1: The Child Might Die First

Dad has a bank account containing $40,000. He adds his son’s name to the account. Then, his son dies. The IRS, holding that the son was a 50% owner in the property, requires the son’s estate to pay estate taxes on $20,000. Thus, Dad loses as much as $9,600. Dad can avoid this only if he can prove that the property was originally his, and not his son’s — something that can be difficult to prove.

Reason #2: The Child Might Steal Your Property

Sometime after Dad adds his son’s name to his bank account, the son makes a substantial withdrawal. The bank permits the son to do this without notifying the father, because the son — being a joint owner — now has legal access to the assets.

Reason #3: You Could Lose Your Assets if Your Child Is Sued

I’m sure you believe that your child would never steal your money. But is it possible that your son or daughter might get into a car accident? If your child loses a judgment, the court could order that half of any assets he holds jointly with you be given to the victor.

Reason #4: You Disinherit Other Children

Not realizing that operation of law takes priority over a will, Mom adds the name of her eldest daughter to all her bank and investments accounts for convenience. When Mom dies, her will — which instructs that all her assets be distributed equally among her four children — is moot, because all her money and investments passed directly to the one daughter listed as joint owner on Mom’s accounts! If the daughter chooses, she can keep all the money, and there’s little her brothers and sisters will be able to do about it. If she tries to fulfill Mom’s wishes by redistributing the assets to her siblings, she’ll discover that doing so constitutes making a gift from her to them, rather than an inheritance from Mom to her children. That means the IRS will subject the redistributed assets to a gift tax — at the same tax rates as those used to assess estate taxes.

Reason #5: The Parent Causes the Child to Lose Big Tax Breaks

In each of the above cases, it’s the parent who suffers. But sometimes the child can be the one at risk. In a recent case, Dad helped his son buy a house, and to protect his father’s financial interests, the son added his dad’s name to the deed. The son then accepted a job transfer to another state and sold the house. He returned to his dad the money his father had put up. The son then deducted his moving expenses on his tax return. The IRS denied 50% of the deduction, arguing that the son owned only 50% of the property. It didn’t matter that the father was on the deed merely to satisfy the lender’s requirements. Nor did it matter that the father was a family member — the IRS held that the father didn’t qualify as a “family member” because he was not a dependent. And the IRS even ignored the fact that the father’s name was removed from the deed prior to settlement. The key issue, the IRS said, was that the father was an owner at the time the son agreed to take the new job.

Such are the games that tax laws play. By solving one problem, you create another. How then, can you avoid both?

The Right Way

Contact me and I will show you.

Financial/Estate Planner-

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*note* I am not an attorney and none of this can be construes as legal advise. consult proper legal council