Making the transition from your current home to a smaller one is not just a real estate transaction. Especially if you're older, downsizing could have major implications for your financial well-being and your estate plan.
“There are several major considerations when downsizing that one needs to understand," said Alma Banuelos, national head of trust and estate services for City National Bank.
“Decisions need to be made in the context of capital gains taxes, property taxes and estate taxes; your potential need for an income stream in retirement and, if you have adult children who you wish to transfer the property to, their resources and appetite for moving into your former home."
For many retirees and pre-retirees, the most common choice when downsizing is to sell their property, said Bill Ringham, director of private wealth services for RBC Wealth Management in Minneapolis.
“House appreciation is a big part of people's net worth and if they don't need the space, they can use the profit from the sale to buy a smaller, maintenance-free condo or townhouse," Ringham said. “The rest of the profit can be invested or, in some cases, people choose to buy a vacation home so that they can split their time between a small place near family in their home town and a condo in Florida or a mountain cabin."
But there's much more to consider when making the downsizing decision.
Federal income tax rules can incentivize selling even if you've owned your home for a long time and it has significantly increased in value. As long as you have owned the property and lived in it for two of the previous five years, you can exclude up to $250,000 of profit from taxes if you file as a single taxpayer and up to $500,000 if you file jointly. In high-cost housing markets, however, that exemption may still be inadequate.
“The difference between what you paid and what your home is worth now can be significant, particularly in high-cost housing markets like California, where someone could have paid $500,000 30 years ago for a house that's now worth $5 million," said Banuelos.
“The question is whether paying capital gains tax on the sale makes financial sense, or whether it's best to hold on to the property so your children inherit it under estate tax rules."
The IRS exempts $11.4 million of total assets in 2019 from estate taxes, so in cases when selling your property would result in a capital gain, it can be beneficial to keep the property in your name as part of your estate to take advantage of the step-up in basis thus avoiding or mitigating capital gains tax, said Banuelos.
If your kids live in the same city as you, it's possible they'll want to purchase your home at a favorable interest rate, especially if it is in a desirable neighborhood with good schools that your kids might not otherwise be able to afford, said Ringham.
“You can structure the sale so that the parents are the mortgagors with an intra-family loan, making the payments more palatable," Ringham said, noting the importance of making it an official loan, with proper documentation to meet IRS standards. If you have the means, you can even split the transaction between a gift and a sale, essentially giving them their inheritance earlier, he added.
The IRS requires private loans between family members to have a minimum interest rate that is typically a little below market rate. The payments can be more affordable if extended for a longer term.
But before you contemplate selling your home to your adult child, you'll of course need to ascertain if the child is interested in purchasing it and has the means to maintain it.
“If your children are young and early in their careers, they may not have the resources to maintain a 5,000-square-foot house and pay the property taxes," said Banuelos. If you have the means, you can establish funds within a trust to cover the property's estimated expenses for a decade - or as long as the funds last.
In addition, you'll need to navigate the relationships with other siblings and develop a plan for equitable compensation in your estate plan.
Just be aware that selling to a child can become problematic if the property represents a significant portion of your net worth and you're relying on its sale to purchase your next place or fund your retirement portfolio.
If that's your situation, you'll need to be careful to sell the home at a price that meets your needs and/or establish loan payments that are sufficient to supplement your retirement savings.
An alternative to selling your home is to transfer its ownership as a gift. IRS rules allow an annual gift of up to $15,000 per person ($30,000 if you and your spouse gift money jointly) and a basic lifetime gift and estate tax exemption of $11.4 million.
If you gift your house immediately, you can first reduce the tax burden with the annual gift tax allowance and then make the remainder a part of your lifetime exemption. For example, if your home is valued at $500,000, you could exclude as much as $60,000 if you and your spouse gift the home to your child and your child's spouse; leaving $440,000 to reduce your lifetime tax exemption.
“In California, there's also a parent-child exclusion that means the child owns the property at your cost rather than a reassessed value, so the property taxes remain the same," said Banuelos. “That can be a huge advantage, especially if the parents have owned the house for a long time."
Another gifting option is a Qualified Personal Residence Trust. A QPRT transfers an interest in your residence to your children, which you or they must live in during the period of the trust.
The trust period can be any length of time, but the estate planning advantages of a QPRT are realized only when the parents outlive the trust. At end of the trust, the parents must pay rent if they want to keep living in the property, since full ownership is turned over to the beneficiaries at that time.
“Parents can gift the house specifically to one child in the future and then even out the inheritance with their other children through the portfolio of investments or other assets that comprise their estate," said Ringham.
If your home is in a desirable neighborhood where people can't afford to buy or the growth potential is significant, a long-term lease could be another potential source of income, said Banuelos.
“If your home is 50 percent of your net worth, you may want to consider renting it for cash flow, especially if your intent is to keep the home for estate planning purposes and your desire to transfer the home to your children for its growth potential in the future ," said Banuelos.
However, turning your principal residence into an investment property is an option that few downsizing homeowners choose, said Ringham. “Oftentimes people don't want to be landlords, especially if they're moving out of state," he said.
If you don't want to manage property and tenants, but you find this option attractive, you'll want to be sure the income created from the rent will allow you to hire a property manager.
“It's also important to be cognizant of the fact that if you plan to sell later [during your lifetime] you could be jeopardizing your capital gains tax exclusion if you don't live in the property for two out of five years before you sell it," said Ringham.
Renting to a family member is another option and could be part of a long-term strategy to gift your home to your children while providing you with a steady source of income.
If you have several children, your decisions about how to transfer ownership of your current home should be made in the context of your overall estate plan.
“In my 30 years' of trust administration, I've often seen parents who want to believe that their children will be of one mind and who forget the years of listening to their children argue in the backseat of the car," said Banuelos. “Take those childhood arguments and add money to the equation and you've got a potential problem."
Even if they get along beautifully, adult children are typically at different stages of their lives and frequently have different aspirations and agendas.
“The best thing parents can do to prevent conflict is to set out, in writing, exactly what they want to have happen and communicate openly as to their intent. That way, no one can imply a sibling had undue influence on mom or dad," said Banuelos.
“The parents should also have a conversation with their kids children to explain why they made the plans they've put in place. I've sat with a mother as she explained her choices to her two sons. Parents are in an ideal position to explain that their home is part of their estate and they can determine what is best for their estate."
Whether you choose to transfer or retain your current home when you downsize, consult your estate planner and tax advisor to compare the consequences of various options before you finalize your decision.
Given the complexity and number of options available when preparing to downsize, it's important to consult with professionals to evaluate your situation before deciding what to do with your property.
City National Bank's wealth planners can help you weigh your options. To learn more, contact us.
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