Dear Liz: You recently answered a question about capital gains taxes that stemmed from two siblings selling their parents’ home. The children had been added to the parents’ deed, presumably before the parents’ death. You mentioned that the capital gains tax would have been avoided if the parents had bequeathed the home rather than gifting it during their lifetimes. Presumably bequeathing the home at death would have necessitated probate and incurred inheritance taxes. Are these costs more than offset by the stepped-up tax basis received?
Answer: Your questions illustrate exactly why no parent should add a child (or anyone else) to a home deed without discussing the issue with an estate-planning attorney first. Too often, laypeople misunderstand what’s involved in probate and make expensive mistakes trying to avoid it.
In some states, probate — the court process that typically follows death — is relatively swift and not very expensive. Trying to avoid it isn’t necessarily cost effective. In other states, including California, the process potentially can take many months and eat up a good chunk of an estate. When that’s the case, it can be prudent to take steps during life to sidestep probate at death.
There are often better ways to do so, however, than adding someone to a deed. A living trust, for example, can be a good way to avoid probate and preserve the tax benefits of bequeathing, rather than gifting, assets. Living trusts can vary in cost, but a lawyer can typically set one up for $2,000 or $3,000. If you compare that with the $25,000 or more the siblings will pay in capital gains on a relatively modest home sale, you can see that the living trust probably is a better deal.
Now let’s turn to the issue of estate taxes. If the assets left by the deceased are substantial enough to incur estate taxes, they will do so whether or not the estate goes through probate. Avoiding probate, in other words, does not avoid estate taxes. Currently, only estates worth more than $5.12 million face federal estate taxes. That limit is scheduled to drop next year to $1 million, but will still affect relatively few estates.
Dear Liz: Your column on the tax issues that develop when parents deed their property to their children should help educate a lot of people. But sometimes this is done to reduce the parents’ assets so they will be eligible for Medicaid after the expiration of the look-back period. In this case, paying the capital gains tax is appropriate, because they are asking the state to pay potentially very large senior care bills.
Answer: Some would question whether it’s ever appropriate for seniors to deliberately impoverish themselves by transferring away assets in order to qualify for Medicaid, which pays long-term care expenses for the indigent. The “look back” period, in which states examine asset transfers before a Medicaid application, was established to discourage such maneuvers. Once again, it’s smart to get a legal opinion before transferring big assets. An elder-law attorney could weigh in on the pros and cons of Medicaid planning.
Dear Liz: My wife and her brother are selling their parents’ home. The parents transferred the deed to their children’s names years ago. My wife should receive about $85,000 from the sale. Our yearly income (one salary; she’s a stay-at-home mom) is around $75,000. My wife is worried about capital gains taxes and wants to reinvest in another real estate property because she’s heard that that will eliminate the capital gains tax. Is that correct? I would really rather invest that money in our current home (finish the basement into a family room, update some items) and pay off our car loan than worry about another property to take care of. What do you think?
Answer: A 1031 exchange is a tax maneuver that allows owners of business or investment property to swap the real estate they have with another property, a transaction that can defer (but not necessarily eliminate) capital gains taxes.
It’s questionable whether your in-laws’ home would qualify as business or investment property, said Mark Luscombe, principal federal tax analyst for tax research firm CCH.
“Were the parents paying rent to the children after the title was passed to the children? If the kids owned the property and the parents were living there without paying rent, I do not think that would constitute investment property,” Luscombe said. “Perhaps if the parents were still paying upkeep expenses and real estate taxes, that might approach the equivalence of rent.”
If there’s a chance the property might qualify, your wife should consult a tax pro experienced with 1031 exchanges for details. Otherwise, she’ll need to write some good-sized checks to the tax authorities. Currently the federal capital gains tax rate is a maximum of 15%, although it will rise to 20% on Jan. 1 if Congress doesn’t reach a compromise on the so-called fiscal cliff. Add to that any state or local taxes on capital gains.
You may think of these taxes as a small price to pay compared with the risk of owning a piece of rental property. Your wife may have another concern that she has not voiced, however: She may not want this legacy from her parents to disappear into the general family budget. She may feel an obligation to preserve and try to grow the money, rather than sinking it into home improvements and other consumption. Legally, gifts and inheritances are considered separate property owned only by the spouse to whom they were given, even in community property states where most other assets are considered jointly owned.
If she wants to keep this money separate, in other words, that’s her right. It would be nice if she carved out a small chunk for family consumption, but she’s under no obligation to do so. If a 1031 exchange isn’t possible or feasible, then she could consult a fee-only planner about other ways to invest the money for the future.
By the way, it needs to be said: This tax bill was avoidable. If your in-laws had, instead of gifting the property, waited and bequeathed it at their deaths, the home would have received a so-called step-up in tax basis. Such a step-up in effect eliminates the need to pay capital gains taxes on any home price appreciation that occurred during the parents’ lives. Any parent thinking of adding a child’s name to a real estate deed should first consult an estate planning attorney to understand the ramifications, since gifting property this way can be an expensive mistake.
Dear Liz: I read your response to the person questioning the rationale behind taxpayer-supported federal student loans. Your response was well written, but do you have any information about how much money is owed to the government for student loans and what percentage of all the loans are actually paid back in full? You mentioned that the government can garnish wages and Social Security checks and seize tax refunds, but does the government follow through and hold these people accountable? Does the government have personnel to do this or is this just a threat?
Answer: Millions of unhappy student loan borrowers can assure you the government’s considerable powers to collect defaulted student loans are much more than a threat. In addition to its own collection activities, the U.S. Department of Education also hires a number of private collection agencies to help recoup what’s owed.
As a result, the government collects more than 100 cents on every defaulted dollar once accumulated interest and penalties are included, according to the Education Department’s most recent report. On a net present value basis — when future collections are discounted back to today’s dollars — the government recovers about 80% of the defaulted debt.
Decades ago, it was possible to skip out on federal student loan debt without serious consequences. Public outrage over that fact led to much stronger collection efforts. That has resulted in the federal government recovering about $10 billion in defaulted student loan debt every year, said Mark Kantrowitz, publisher of the FinAid.org and FastWeb financial aid sites.
Dear Liz: I recently bought a new car, and the dealer, after running a credit check, told me my Experian score was 783. I have had only credit cards and no loans. This is my first auto loan. They gave me a 3.5% interest rate and I took it reluctantly. I do not like the rate and the need to pay huge interest over time, and am considering paying off the loan as soon as possible as there are no pre-payment penalties. If I am able to pay off my loan in a couple of months (instead of the original five-year loan term), will this improve or adversely affect my credit score? How will this look in the eyes of future lenders?
Answer: Paying off debt is a good thing, both for your credit scores and your wallet. The leading FICO credit scoring formula likes to see a big gap between your available credit and the amount you’re using. This is particularly true with revolving accounts, such as credit cards, but your scores also get a boost from paying down installment debt, such as auto loans and mortgages.
By the way, a 3.5% rate isn’t bad and wouldn’t cause you to pay “huge” interest. But you probably would have gotten a better rate had you arranged your financing in advance, say with a local credit union. If the dealership then offered you a better deal, you could cancel your application with the credit union. As it was, you left yourself at the mercy of the dealer — not a good idea.
Once you get this loan paid off, consider making the same-sized payments to a savings account so you can pay cash for your next car. If you do decide to finance again, try to keep your loan term to three or four years. That will help ensure you don’t buy more car than you can afford and could prevent you from being “upside down” (owing more than the car is worth) for much of the loan term, as is often the case with longer loans.
Dear Liz: I will be 61 in December. I have $15,000 in credit card debt at 9.9% and $41,000 in a certificate of deposit earning 3% per year. I have $590,000 in my 401(k) account. I want to pay off the credit card balance to redirect my income to paying off my $26,000 mortgage by the end of 2013. Which near-term option for paying off the credit card is better: close the CD and buy a new, lower-paying CD with the balance after paying the card off, or take a 401(k) distribution, leaving the $41,000 emergency fund untouched?
Answer: Since you’re older than 591/2, you would not have to pay penalties on any withdrawal from your 401(k). But a withdrawal would still be a bad idea for a number of reasons.
The most obvious is that you would have to pay taxes on any amount you take out. Typically 20% is withheld from any distribution, but your bill could well be higher depending on your federal and state tax brackets. In the 25% federal and 8% state brackets, you’d owe $3,750 in federal and $1,200 in state taxes on a $15,000 withdrawal. So even without penalties, you’d lose one-third of a withdrawal to taxes.
The money you take out also wouldn’t be able to earn any future tax-deferred returns for you. At 60, you have a life expectancy of a couple more decades. The money you plan to withdraw potentially could grow to more than $70,000, assuming 8% average annual returns, if you leave it alone.
So using 401(k) money to pay debt is almost as dumb for you as it would be for a younger person who would pay penalties and incur an even bigger potential loss of future tax-deferred money.
Use the CD money instead, and change your spending habits so you don’t incur any future credit card debt.
Dear Liz: I am increasingly annoyed by the entitlement attitude of today’s students. Why should the taxpayers (me) pay to educate somebody else’s children? I remember when there was no such thing as a student loan. If I wanted to go to college and didn’t have the money for tuition, I delayed starting college until I had worked for a year and saved up the money. Many of my friends did this, as did I. Now these kids stand around with their hands out looking for somebody to bring them their education on a silver platter. I wish you would say something about this in your column.
Answer: Let’s start with the obvious, which is that an education costs a heck of a lot more than it did when you were in college.
The College Board reports that a student attending an in-state, four-year public university needs to budget an average of $22,261 to pay for the 2012-13 year. Which means the total cost to get an undergraduate degree would be about $90,000, assuming he or she can get all the required courses in four years (something that’s increasingly difficult because of state budget cuts in education).
Not to put too fine a point on it, but there aren’t many jobs these days that would enable someone (particularly someone without a college degree) to save the full cost of a college education in a single year. Even someone who started out with two years of community college would need to budget about $8,000 for each of those years, according to the College Board, and the total cost of a four-year degree would still be around $60,000. Some people would pay less if they got a lot of financial aid or lived at home, but any way you cut it, the tab is much, much higher than it has been in decades past.
Something else has changed since you were a student, and that’s the importance of having a college education if you want to have a decent financial life and remain in the middle class. In your day, people without college educations — even those without high school diplomas — could find well-paying jobs. Those jobs have increasingly been phased out by technology or they’ve gone overseas. The manufacturing and technical jobs that remain often require at least some post-secondary education. Having a college degree is what having a high school diploma used to be — an essential entry-level credential in many fields.
Our nation and our economy need educated workers if we’re to be competitive in a global economy. It also would help to have an expanding pool of well-paid workers to pay taxes toward things like roads, defense, police and fire protection and Social Security, from which you presumably benefit.
This is why governments promote post-secondary education with a relatively small amount of grants for the needy, and a relatively large amount of loans for everyone else. The first federal student loans were part of the National Defense Education Act of 1958; today, most students borrow at least some portion of their education costs.
You see, most kids (and their parents) aren’t standing around waiting for a handout. Most financial aid these days comes in the form of loans, which have to be paid back. These loans aren’t necessarily cheap — the rate on a Stafford student loan is 6.8%, while graduate and parent PLUS loans have 7.9% rates (plus a 4% origination fee that’s deducted from each disbursement).
If students or their parents default, the government can garnish their wages, seize their tax refunds, take a chunk of their Social Security checks and trash their credit. There is no statute of limitations on federal student loans and only rare relief in Bankruptcy Court, so borrowers can be pursued to their graves for what they owe.
Yes, many families overspend on education and overdose on student loans. The majority, however, graduate with a reasonable amount of debt (about $26,000 on average) that can be repaid from their now-higher earnings. Student loans aren’t a handout — they’re an investment in both the graduate and our economy.
Dear Liz: I am the single mother of four daughters, including one who has a serious heart condition that causes $10,000 to $30,000 in out-of-pocket medical expenses each year. These medical bills have caused me to file bankruptcy twice, but the bankruptcies have not wiped out my student loans.
I have qualified for minimum payments and deferments a couple of times but have been on a payment schedule the vast majority of the time. The interest grows faster than I can keep up, and I keep getting deeper into the hole. I am now 51 and have over $45,000 in student loans. After a year and a half of being unemployed, and depleting my retirement funds to pay for COBRA health coverage, I finally found a job — I am making $30,000 a year working for a nonprofit as a social worker — but I still can’t make any progress on these loans.
The only program I can find is one in which I have to make payments, no matter how little I have, for the next 10 years if I continue to work for only nonprofits. No one can explain to me why all the money I have already paid, plus only working for nonprofits, plus my volunteer service over the years, doesn’t count for something. I am holding my breath hoping you might have some suggestions to share.
Answer: The Public Service Loan Forgiveness Program you discovered is actually a fairly recent development. Before 2007, people in your situation didn’t have an option to have their balances erased.
It’s unfortunate you didn’t know about the program earlier, since if you’d signed up when it first became available you could be partway through your required payments by now and only a few years away from having your balance forgiven.
But better late than never. The program is ideal for those who have big federal student loan debts and small incomes. If you sign up for the “income-based repayment” option, your monthly payments will be limited to 15% of your “discretionary income,” defined as the amount of your income over 150% of the poverty line for your family. Since the poverty line for a family of five is $27,010 in 2012, your required monthly payment may well be zero. Even if your household is smaller, payments under the program typically are less than 10% of your gross income, said Mark Kantrowitz, publisher of the FinAid and Fastweb financial aid sites.
If you didn’t have a public service job, your required repayment period would be 25 years — so you are receiving some credit for your service. Public service jobs include, among others, those in public safety and law enforcement, military service, public health, public education, public interest legal services, social work in public or family service agencies and jobs at tax-exempt 501(c)(3) organizations. Government employees also are considered to have public service positions, although interestingly enough, time served as a member of Congress doesn’t count.
Dear Liz: Your answer to the parents with $200,000 in student loans for their daughters’ educations was interesting — and cautionary. I wonder, since they mentioned refinancing their home, why not explore using their equity by selling the home and renting?
Depending on the amount they have in the home, they might be able to fund more retirement as well as reduce the loan balance. Also depending on the size of the mortgage, they might be able to rent for the same monthly amount or less. Presumably, their house was big enough for four, but now they could “live well with less.” And be more flexible.
Answer: The writer did mention getting a new mortgage, but didn’t say whether it was a refinance or a modification, or whether the couple had any equity in the home. Although a conventional refinance requires considerable equity, a mortgage modification or a refinance made through the government’s HARP program would not require that they owe less than the house is worth.
If they do have equity, it would be worth considering using at least some of it to alleviate their debt burden and supplement their retirement funds. If they don’t have equity, selling the house might still be an option if they could substantially reduce their living costs. Given that their income plunged by more than half, they would be smart to cut their expenses as far as possible to free up money to save for retirement and pay their debts. Taking such a big step down in their lifestyle might be painful, but it’s often to better to do so now rather than risk being old and broke.