I own a rental home in California. How can I leave it to my daughter so she can avoid capital gains taxes?

best inexpensive laptop - #1:I own a rental home in California. How can I leave it to my daughter so she can avoid capital gains taxes?

 

 I live in California and own a single-family rental property that has a tenant with a 12-month renewable lease. The home is in a revocable trust.

I would like to leave the property to my daughter. I have one other child who I don’t intend to leave any of this property to.

My daughter will probably keep the property as a rental, but she might use it as a second home and/or as a partial, week-to-week vacation rental.

How do I structure my will to leave the property to her so she can avoid probate and paying capital-gains taxes?

Sincerely,

LA Landlady

‘The Big Move’ is a MarketWatch column looking at the ins and outs of real estate, from navigating the search for a new home to applying for a mortgage.

Do you have a question about buying or selling a home? Do you want to know where your next move should be? Email Jacob Passy at TheBigMove@marketwatch.com.
Dear Landlady,

Since starting this column about a year ago, one of the most common questions I get is about the best way to leave a home to one’s children. Parents recognize that real estate is a useful avenue toward building generational wealth, and they want to ensure that their children get the most out of their inheritance.

It makes sense that you want to avoid probate — in many states, it’s a costly process, and the fees involved can eat into the value of the estate.

Your situation is a little more complex though, because the property isn’t your primary residence, but a rental home. So there are different considerations involved.

I polled financial advisers to get different strategies that address your concerns. The first and potentially easiest option, presented to me by David Bize, a certified financial planner based in Texas, is to convert the property’s deed into a revocable transfer on death deed. This option became available in California in 2016, and is available in 25 other states, plus the District of Columbia.

This deed allows you to leave your property to a designated individual, in this case your daughter, without the need for a trust. Because of the way the deed is structured, the home wouldn’t go through probate. Unlike a joint deed, adding her to this deed as your designated grantee isn’t a taxable event in the eyes of the IRS.

There are some drawbacks, though. For instance, if you were to become incapacitated due to an accident or a health event such as a heart attack, your daughter may not be able to revoke the deed herself. That could complicate matters, because doing so might be necessary to qualify you for Medicaid.

Putting a home into a trust, as you have already done, is another common strategy that people use to bypass probate, and one that was recommended to me by many financial advisers.

But there are potential pitfalls — namely in the form of capital gains taxes. After you die, your daughter may wish to sell the property rather than hold onto it. If she were to inherit it through your will and probate, then she would be entitled to a step-up in basis. What that means is that instead of the original price you paid to purchase the rental home, the home’s value at the time of your death would be used to calculate the cost basis (plus any expenses tied to improvements or maintenance.)

If the property has appreciated significantly in value over the years, that could represent a major difference, and without the step-up in basis she could be on the hook for taxes on hundreds of thousands of dollars in profit.

The form the trust takes is critical here. “Assets that bypass the estate through a trust or another mechanism are usually not eligible for a step-up in basis,” Kristin McKenna, managing director at Darrow Wealth Management, wrote in a blog post. However, a home held in a revocable living trust likely would be eligible for the step-up in basis.

One final strategy multiple advisers recommended was to put the home into a limited liability company, or LLC. This route would have benefits to you in your lifetime, too, because it protects your personal assets from liability were any financial or other problems to arise in conjunction with the rental home. Plus, LLCs can attract better tax treatment, in some cases.