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Article 2
Buying or Financing a Home for Your Parents – Consider an Irrevocable Trust
Written By: Alan Gassman, JD, LL.M. (Taxation), AEP (Distinguished) & Brandon Ketron
Background
A great many retired Americans do not have significant financial resources to pay for all of their expenses and provide a nice home or condominium for living. Many of the children of these parents may wish to help buy or finance a homestead that may also be a reasonable investment for the children, and a tax efficient one at that.
Often one or more financially successful children will provide the financing payment or downpayment for a home and will expect to receive their contribution and possible appreciation of the home back as opposed to sharing this with siblings and other beneficiaries.
Currently, there are many different ways for someone to purchase or finance a home for their parent or parents. These include the following:
1) An Irrevocable Trust that can benefit both the parent and the family of the child, and possibly even the child.
2) Loaning money to the parent.
3) Co-owning the property with the parent as joint owners or with the parent owning a life estate and the contributing child having the remainder interest..
We discuss these, and various considerations associated therewith.
What to Consider Before Choosing a Plan
Factors to take into consideration include protection of the value of the home and appreciation from potential creditors, a change in the estate plan of the parent or parents, the possible impact that the existence of the home could have on Medicaid eligibility, and what might happen if the parent or parents become at odds with the child or the child’s family.
Another consideration is whether an appreciated home will receive a new fair market value income tax basis on the death of a parent or the surviving parent, so that the child who has paid for the home would be able to sell it following the parents’ death without paying capital gains taxes.
Establishing an Irrevocable Trust
For the above reasons, it is now common for a well-advised child to establish an irrevocable Trust for the benefit of the child’s spouse and descendants and to make the down payment or entire purchase contribution to the Trust in order to achieve the following:
1) The Trust can be held for the aging parent or parents unless or until the Trustee determines that it is best to terminate their use rights or modify the situation, such as by selling the home when it is time for the parent to move to an ACLF or other type of facility or into the home of one or more of the child and the child’s siblings.
2) The child can serve as Trustee of the Trust if there are no federal estate tax concerns resulting from the size of the child’s estate, or if not, the child can have the right to replace the Trustee of the Trust with any individual or Trust company that is not an employee or relative of the child.
3) The Trustee of the Trust can make sure that all insurances, taxes, and mortgage payments are made timely, and that the maintenance of the home occurs, notwithstanding whether the parent might become disorganized or even evasive with respect to this information.
Estrangement between family members is not at all unusual, especially as individuals get older and may have dementia or similar mental situations, and/or be influenced by those who are in or come into their lives. Literature indicates that over 25% of Americans are estranged from an least one family member, and we know many people who wish that they were estranged even when they are not.
4) The house and equity therein will be safe from potential undue influence exercised against the parent or parents or unwise financial or physical decisions that they might make or that might be made for them.
5) The Trustee would not need to adhere to court oversight if the parent ever became unruly or mentally unsound and a judge appoint a guardian to oversee all assets and activities of the parent.
6) If the parent dies and has what is known as a “General Power of Appointment” over the Trust assets, then the Trust assets can receive a new fair market value income tax basis, so the home could thereafter be sold with no capital gains tax being paid on sales proceeds up to the fair market value date of death for the home, as described in more detail at Subsection 5 below. This will normally involve giving the parent a power to direct Trust assets to creditors of the parent’s estate, subject to receiving consent from one or more “non-adverse, non-fiduciary” parties.
7) An estate-taxable child can keep the value of the home and growth thereon out of his or her estate for federal estate tax purposes.
8) In Florida, the beneficiary of a trust that owns a homestead can qualify the property for the homestead tax exemption if certain language is included in the Trust Agreement, and the identity of the homeowner and the qualifying beneficiary of the Trust may be kept confidential in many jurisdictions by proper drafting and property tax appraiser interaction.
9) If two or more children would like to provide such a benefit for their parents, they could share an irrevocable trust that would divide into separate trusts for the families of each separate child on the death of the survivor of the parents or when determined by individuals named in the Trust Agreement, or they could establish separate trusts and have each trust own a portion of the home.
The primary disadvantages of the above trust arrangement are as follows:
1) The inconvenience and expense of establishing an irrevocable Trust, maintaining a separate checking account, and explaining to accountants that such a Trust does not have to file a federal income tax return and that its assets can be considered as owned by the child.
2) The inability to have the home sold during the life of one or both parents without having the advantage of a $250,000 per person capital gains exclusion under Section 121 of the Internal Revenue Code, unless the home is sold or transferred by the Trust to the parent at least 2 years before sale to qualify for the exclusion.
3) The parent or parents may feel insecure by not being the owners of the home and may prefer to owe a mortgage to the child and to also have the income tax deduction for up to $10,000 a year of property taxes if the parent or parents itemize their annual income tax deductions, which will be very unusual unless they have large medical expenses. Presently, the standard income tax deduction a U.S. citizen receives without itemizing deductions is $13,850 for a single individual and $27,700 for a married couple.
Medical and required nursing expenses are only countable as deductible expenses if they exceed 7.5% of an individual or married couple’s adjusted gross income.
Home mortgage interest expenses can also be deductible on a primary residence.
4) Under a typical Spousal Limited Access Trust or Trust for descendants, the grantor/child is not a beneficiary and cannot directly benefit from the Trust, although the child’s present and/or future spouse and children can benefit.
If such a Trust is formed in an “Asset Protection” jurisdiction such as Nevada, Alaska, South Dakota, or Delaware, then it is possible to provide that the child will have the ability to become a beneficiary of the Trust under certain circumstances, such as in the event of an unexpected financial hardship.
5) In order to qualify for the new fair market value income tax basis on the death of the parent as mentioned in Section 6 above of the preceding Section, the gift to the Trust by the child will need to be considered “complete” for federal estate and gift tax purposes.
Generally, if the gift exceeds $17,000 per beneficiary of a properly drafted Trust having “Crummey powers”, then a federal gift tax return Form 709 has to be filed, but no gift tax will be owed unless or until the child has used the child’s entire $12,920,000 estate and gift tax exemption.
It is possible to have the transfer to the Trust considered an “incomplete gift” so that no gift tax would have to be filed, but doing so would make it doubtful as to whether a new fair market value income tax basis would be obtained on the parent’s death.
It is also possible to leverage the gift by having the child make both a transfer of 10% or more of the purchase price of the home by gift and a loan to the Trust for the remaining amounts needed that can bear below market interest at the applicable federal rate and allow the child to get back the amount loaned, plus interest, upon the eventual sale of the home. The interest paid on the loan will not need to be reported for income tax purposes if the Trust is drafted to be “disregarded” for income tax purposes.
6) Another possible consideration is whether property and liability insurances will cost more if they result from a home owned by an irrevocable Trust as opposed to being owned by the individual homeowner or a renter.
Many carriers will have different kinds of policies and charges to apply to a home held in trust as compared to a home owned outright.
Loaning Money to the Parent(s)
The advantages of simply lending money and taking a first or second mortgage on a parent’s home are as follows:
1) This will be simpler than setting up a Trust.
2) The parent or parents will have the ability to sell the home at a gain, and exclude up to $250,000 per parent from capital gains tax on the sale.
3) The parents will have pride of ownership and the security that the home will not be taken away without their consent if they make the mortgage payments.
4) The income tax deduction for up to $10,000 of property taxes and interest paid on a home mortgage, if they itemize deductions, as described above, and the amounts owed are secured by a mortgage and other income tax deduction rules associated with residences allow this.
5) The new income tax basis that will be received on the death of a parent or parents to reduce capital gains taxes if the property appreciates.
6) The parents preserve other assets and peace of mind.
The downsides to the child providing financing with respect to this are as follows:
1) Interest at the Applicable Federal Rate (presently 4.19% for loans over 9 years) has to be included in the child’s income, even if interest is not paid on the loan, under the related party interest income rules (IRC Section 267). Higher interest may be charged if determined appropriate, but the Applicable Federal Rate is the minimum interest that will be imputed to the child under this type of arrangement.
2) Uncertainty as to whether the parent will leave the home to the child on death.
In conclusion, the child lending money to the retired parent(s) may be a more attractive option to exercise if said child is looking for a more straightforward solution; however, it does not offer the same advantages as establishing an irrevocable trust.
Considerations of Granting a Life Estate to the Parent, with a Remainder Interest to the Child.
Another alternative is for the parent to donate or receive a gift to enable paying a sufficient amount to own a life estate in the property being acquired, and allowing the child or a Trust formed by the child to own the remainder interest.
1) Under a split purchase, the parent or parents would buy the life estate or life estates, and the property and the child would pay for the remainder interest.
2) Using the August 2023 7520 rate of 5% and IRS actuarial tables, which probably undervalue a life estate, a 75-year-old male’s life expectancy is 7 years, and a 75-year-old female’s life expectancy is 9 years. The value of a life estate in a $1,000,000 home would be $496,130 (49.613% of the value of the home).
If the parent or parents can contribute $496,130, which is not considered to be a gift by the parent, and the child contributes $503,870, then there is no loan arrangement, and the child simply owns the home after the parent dies under the life estate arrangement.
On the death of the parent the child owns the entire home and has not received any gift.
3) Life estate holders normally pay for all insurances, routine maintenance, property taxes, utilities, landscaping, homeowners and condo association dues, and similar expenses.
4) The remainder interest holder will normally be required to contribute towards major repairs, refurbishment, condominium, homeowner, and property tax special assessments.
5) On the parents’ death, there is a step up in basis, and the child automatically owns the home.
6) A parent cannot change his or her estate plan with respect to what occurs after death, but he or she could assign the life estate or sell it to a third party if anyone is willing to pay for it.
Co-owning the Property with the Parent(s)
According to CEIC Data, a team of expert economists and analysts, US housing prices grew 8.8% year-over-year in December 2022, following an increase of 12.2% year-over-year in the previous quarter. The increasing unaffordability of homeownership has left countless people seeking alternative solutions, making co-ownership an attractive option for many.
Co-ownership involves purchasing the house together with your parent(s). All co-owners would be on the title of the home and also likely on the mortgage loan.
There are two main ways to co-own a home with parents.
1) Tenancy in common: This option allows for the share of ownership to be proportional to how much money each person invests in the property. For example, if the child invests 80% of the money into the property, they would own 80%. Each person would still have equal rights to all areas of the property, and each person may choose who gets their share of the property upon their passing. Selling the property under this form of co-ownership would require the consent of all parties.
2) Joint Tenancy: With this form of ownership, each person would have an equal share of the home, regardless of how much they invested; however, no one would be able to choose their own beneficiaries in the event of their passing. The surviving owners would automatically receive the deceased’s share and divide it equally among the remaining co-owners. Additionally, any owner may sell their share of the home to any other person without the consent of the other co-owners.
The parents can pay rent to the child based upon the fair market rental value of the home multiplied by the percentage owned by the child, and deduct rental expense as long as a written agreement satisfies Internal Revenue Code Section 280(A)(d)(3) (known as a “share equity financing agreement”) is satisfied.
Section 280(a)(d)(3) reads as follows:
(3) Rental to family member, etc., for use as principal residence
(A) In general
A taxpayer shall not be treated as using a dwelling unit for personal purposes by reason of a rental arrangement for any period if for such period such dwelling unit is rented, at a fair rental, to any person for use as such person’s principal residence.
(B) Special rules for rental to person having interest in unit
(i) Rental must be pursuant to shared equity financing agreement
Subparagraph (A) shall apply to a rental to a person who has an interest in the dwelling unit only if such rental is pursuant to a shared equity financing agreement.
(ii) Determination of fair rental
In the case of a rental pursuant to a shared equity financing agreement, fair rental shall be determined as of the time the agreement is entered into and by taking into account the occupant’s qualified ownership interest.
(C) Shared equity financing agreement
For purposes of this paragraph, the term “shared equity financing agreement” means an agreement under which—
(i) 2 or more persons acquire qualified ownership interests in a dwelling unit, and
(ii) the person (or persons) holding 1 or more of such interests—
(I) is entitled to occupy the dwelling unit for use as a principal residence, and
(II) is required to pay rent to 1 or more other persons holding qualified ownership interests in the dwelling unit.
(D) Qualified ownership interest
For purposes of this paragraph, the term “qualified ownership interest” means an undivided interest for more than 50 years in the entire dwelling unit and appurtenant land being acquired in the transaction to which the shared equity financing agreement relates.
No matter how a person chooses to co-own the home with their parents, they will all be equally responsible for the debt on the property.
Taking into account the above, a child may choose to co-own a home as tenants in common with their parent(s). Since they would all be equally responsible for the mortgage loan, this would allow the child to make full payments on behalf of their parents on their own.
Final Word
Overall, an individual looking to purchase or finance their home for their aging parents will have to identify their most important needs in order to be able to choose the best route to take in homestead planning for their family.
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