Making Vital Estate Decisions for the Next Generation

A growing number of residents in the San Fernando Valley and Ventura County are graying--and trying to figure out the best way to one day pass on their homes to children and grandchildren.

Nobody likes to think about his own mortality. But if you’re concerned about the welfare of your heirs, it’s worth taking the time to learn how property--both real estate and personal--can be passed on to the next generation.

“Deciding how your estate will be distributed involves both emotional and financial issues,” observed Tom Boyle, partner at the accounting firm of Deloitte & Touche LLP, which has offices in Woodland Hills. Because many people don’t want to deal with the touchy subject of their own demise, they don’t do the proper planning, Boyle said.

“Even among my own peers and associates it’s not surprising to find people without so much as a will,” he said.

The law says spouses can pass their whole estate to their mates basically free of estate taxes, or they can leave up to $600,000 to their heirs without any taxes due the Internal Revenue Service.

There are a variety of ways to pass on property to children, grandchildren or others:

* Wills:

There is a long tradition of passing property on to others after death through a will. This can take the form of either a formal will (witnessed by at least two people) or an unwitnessed, handwritten (holographic) will, which is legal in California. Each person in a will can leave up to $600,000 to designated heirs without any estate tax. The major problem with a will is that it must go through probate--the procedure by which a will is proved to be valid or invalid and through which the provisions of the will are administered.

A Superior Court will generally supervise payments of debts, taxes and probate fees and the distribution of the estate to the heirs. A simple probate can take nine months to one year, and probate fees can total between 4% to 10% of the gross value of an estate. In short, probate can be both arduous and expensive.

* Living Trusts:

These trusts are revocable instruments in which you transfer property from yourself as a so-called trustor to yourself as a so-called trustee. You can still buy, sell, trade and reinvest property that is part of the trust without consent of other parties. Within the trust, you name a successor trustee after your death and those of successor beneficiaries.

Living trusts avoid the nuisance and expense of probate. These trusts, however, won’t be treated any differently from a will when it comes to taxes. If one parent, for example, leaves $800,000 to a child, $600,000 of that will be free of estate taxes. The other $200,000 could leave the child with about a $70,000 in liability for estate taxes, said Denis Clifford, an attorney and author of several books about estate planning for Nolo Press in Berkeley.

A couple that wants to give as much as $1.2 million to a child tax-free would need to create a so-called A-B living trust--in which the first spouse to die leaves his or her half to the surviving spouse in the form of a trust that can be used for the survivor’s maintenance. After the survivor dies, the heirs get both halves of the estate, Clifford explained.

* Joint tenancy:

Some parents avoid probate for their real property by including their children as joint tenants on a title to the parents’ property. But there are a host of problems with joint tenancy, said Alison Whalen, partner in the estate-planning department at the law firm of Irell & Manella in Century City.

Suppose a husband and wife include their son as a joint tenant on their home. But any party to a joint tenancy can sever the joint tenancy and then proceed to will away or set up a mortgage on his or her portion of the property. All this can happen without the other joint tenants knowing about it, Whalen warns.

If you make one of these joint tenancies, and then decide to sell the property, you would need your children’s consent, and the kids won’t be obligated to return their share of the property if you ask for it back.

How much do you really trust your children? This will be a major factor in determining whether joint tenancy makes sense. Also, Whalen said, “Whether or not this method is a sensible way to pass property to children depends on the value of the property, its tax basis, its appreciation potential, the estate tax bracket of the parent and the income tax bracket of the child.”

* Family limited partnerships:

These partnerships can be established with general and limited partners for closely held businesses or real estate. The individual who establishes the partnership, or FLP, will ordinarily serve as general partner and make gifts of limited partnership interests to children, grandchildren or others.

The major advantage of FLPs is that the IRS allows the minority FLP interests to be discounted by 25% to 60% in value, resulting in potentially big tax savings for someone who is given a partnership interest as a gift.

Because the FLP interest being given away is generally less than a majority, the IRS allows for a so-called “lack of marketability discount,” explained Boyle of Deloitte & Touche. The amount of the discount allowed by the IRS depends on just how much control the recipient of the gift has over the property. While FLPs will help the recipient save on gift taxes, Boyle said, the transfer of FLP interests may be subject to state and local transfer taxes.

* TIP trusts:

Qualified terminable interest property trusts are particularly useful where one spouse (the trustor) wants to transfer a home to his or her children eventually--but only after the death of the surviving spouse. That spouse--frequently the partner in a second or third marriage--can enjoy use of and income from the property. But the asset itself is preserved for the trustor’s family or other heirs.

* Additional considerations:

Parents of minor children need to assign title to a custodian who will watch over the property until the children become 18. Those younger can inherit property, but they are considered incompetent to sell it or borrow on it. Another important issue to clarify with a qualified accountant is how a particular property will be valued for calculating capital gains.

The increase in the value of a home or other real property will be subjected to differing capital gains tax treatment--depending on how and when the transfer is made.

Finally, people should be aware of an arcane legal principle known as the rule against perpetuities. This rule requires that an interest in property must take effect within a certain time or else the interest will be considered invalid. People who want to create a mechanism that distributes property more than 20 years after their death should consult an attorney about whether the rule applies to them.