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Parents shouldn't place kids' names on real estate
Unless occupancy rules are met, capital gains tax may be huge
By Benny L. Kass
DEAR BENNY: Twenty years ago my mother placed my name on the deed to avoid issues when she passed on. Will the IRS treat this as inherited property or consider it investment property? Did I inherit her half of the property? --Theo
DEAR THEO: Why, oh why, do parents do this?
For example, let's say your mother and father bought their house years ago for $20,000 (sounds great but that was a lot of money then). For tax purposes, your parent's tax basis was $10,000 each. Your father died 20 years ago, when the house was worth $40,000. Under a legal concept called the "stepped-up basis," the market value on the date your father died was added to your mother's basis. Thus, her basis would be $30,000 (her original $10,000 plus half of the $40,000).
Did your mother add you to title or are you the sole owner? I did not understand your question. A very strict tax rule is that the basis of the person giving the gift (the donor) becomes the basis of the receiver (the donee). So, if my calculations are correct, if you are on title with your mother, your tax basis for half of the property is $15,000. On the other hand, if you are now the sole owner, your basis is $30,000.
Why is this a problem? Because unless you have lived in the property for two out of the previous five years before it is sold -- in which case you can exclude up to $250,000 of any gain or if you are married and file a joint tax return you can exclude up to $500,000 of gain -- you will have to pay a lot of capital gains tax.
If you are now the sole owner, the IRS looks at the difference between the tax basis and the sales price. Any profit that you make is taxable.
If the property has been rented out, then you may want to consider doing a 1031 (Starker) exchange. You will have to discuss all tax issues with your own accountant.
If your mother is still on title, upon her death you will receive the stepped-up basis for her half. But your half is still, unfortunately, the basis described above.
DEAR BENNY: I hold a $120,000 promissory note backed by a first deed of trust in Virginia. The borrower paid back $60,000 in principal in 2001, and I subsequently loaned him back $60,000 in 2004. My thinking was this second advance was covered by the recorded deed of trust and if any dispute ever arose, I could produce the cancelled check and refuse to sign the certificate of satisfaction. Opposing counsel says the 2004 advance is not secured by the deed of trust and is a personal, unsecured loan. Is that correct? --Bob
DEAR BOB: There is an old saying that where there are two attorneys there are three opinions. I do not practice law in Virginia, so you should really get a specific opinion from your own attorney -- or at least ask the other lawyer for his or her legal opinion.
Is there any language in your promissory note and deed of trust that would cover the situation? The problem is simple: Creditors of the person who borrowed the money from you are put on notice of your security interest because it is recorded among the land records in the county where the property is located. However, these creditors want to be paid also, and if they can find a "legal loophole" they will exploit it. And while they are on notice of the original loan, they have no way of knowing that you advanced additional moneys -- even though the amount is the same as reflected in the original note and deed of trust.
The issue of future advances -- sometimes referred to as "dragnet clauses" -- is a very complex area of law. State law -- and the specific terms and conditions of your legal documents -- will determine whether the additional moneys are secured.
The courts will also look to the intentions of the parties. Did your borrower intend that the new loan would, in fact, be covered under the original deed of trust?
I must caution you, however, that in a number of jurisdictions, if any one gets a judgment against your borrower (or a contractor files a mechanic's lien) the second advance that you gave would be junior in priority to those new creditors.
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