01.15.06

First steps towards Ladybird/Beneficiary Deeds in California

Posted in Legislation, Nonprobate transfers at 2:17 pm by gbroiles

Last year, the California Legislature passed - and Governor Schwarzenegger signed - legislation (AB 12) directing the California Law Review Commission to study California’s current methods for transferring property at death, the methods used in other states for transferring property at death, and to consider whether or not California should allow the use of “Ladybird” or “beneficiary deeds”. What is a Ladybird deed, and why should you care?

A Ladybird deed, also known as a beneficiary deed, allows real estate to be transferred at death to another person in a fashion similar to “transfer on death” designations on bank or brokerage accounts.

Currently, California law does not provide for the use of a beneficiary deed. Real property is typically transferred within families using several other methods, each of which have some disadvantages:

1. Joint tenancy. This is a favorite choice for do-it-yourself estate planners because it’s very cheap - the only cost, if you’re willing to use a form provided for free by a title company or found on the Internet, is the cost of recording the deed. Unfortunately, joint tenancy has a number of problems, and I believe it’s the worst (yet most popular) method for inter-family transfers. Joint tenancy makes the joint tenant an owner immediately - which means that the property is immediately available to creditors of the joint tenant, including the IRS, spouses in a divorce action, credit card companies, personal injury plaintiffs, and anyone else who might choose to go after the joint tenant’s assets. Of course, the property remains subject to the creditors of the initial owner, as well, so the risk of adverse events is effectively doubled (or worse).
2. Outright gift. This is another approach popular among people who know just enough to be dangerous to themselves - often it’s an attempt at Medicare/Medi-Cal planning, intended to get assets out of a parent’s estate so that the parent can qualify for public benefits (such as health care) without being forced to subject their home to a reimbursement claim at death. There are three big problems with outright gifts - first, the property is again immediately subject to the recipient’s creditors, which means that if Junior gets divorced, experiences catastrophic medical costs, tax problems or business failure, or otherwise encounters financial distres Mom’s house may be sold out from under her to pay Junior’s debts - even against Junior’s wishes. Further, if Junior’s relationship with Mom deteriorates, Junior can evict Mom or sell the home, leaving Mom homeless and without recourse against Junior. As if that weren’t bad enough, it also leaves Junior in an unfavorable tax position - Junior’s “basis” (meaning his cost, from a tax perspective) will be equal to Mom’s basis in the house, which may be very low, if Mom purchased the house many years ago and didn’t get a step-up (or a full step-up) in basis upon Dad’s death. In concrete terms, this means that if Mom & Dad purchased their house 30 years ago for $40,000, and the house is currently worth $600,000, Mom & Dad could sell the house themselves and pay tax on only $60,000 worth of gain (because Mom & Dad can use the Section 121 exclusion to exempt the first $500,000 of gain from tax when they sell their residence) - so their tax bill, worst case, would probably be approximately $15,000. ($60K of gain x 15% federal long-term capital gain rate = $9000; $60K of gain x 9.3% CA income tax rate = $6000). If Mom & Dad hold onto their home and transfer it to Junior upon the death of the second parent, Junior can sell the home income tax-free if he does so shortly after Mom & Dad’s passing, because his basis will be the fair market value upon the second death .. and if he sells the house at that value, his gain will be small or zero, and hence there will be no taxable income. However, if Mom & Dad give the house to Junior, and Junior sells the house without living in it, he will pay tax on approximately $560,000 worth of gain. Junior’s basis is Mom & Dad’s “carryover” basis of $40K; so he’s probably looking at a tax bill of $140,000 ($560,000 x 15% federal long-term capital gains rate = $84,000; $560K x 9.3% CA income tax rate = $56,000).
3. Will. While a transfer using a will avoids the risks of pre-death transfers of property and preserves the favorable tax aspects of a step-up in gain upon death, in California any property transferred using a will is subject to the formal probate process - which involves significant statutory fees for the executor, the executor’s attorney, and to file the action in the probate court.
4. Living Trust. A transfer through a living trust is probably the best available alternative at this time, if Medi-Cal planning is not necessary or desired. A transfer through a well-drafted iving trust provides for management (and sale, if necessary) by a successor trustee if the owner(s) become incapacitated during their lifetimes; it avoids the risks of a lifetime gift, and preserves the favorable tax attributes of a transfer at death. The disadvantage to a living trust transfer is the expense of setting up the trust - a well-drafted trust from a reputable attorney will likely cost several thousand dollars. While that cost is significantly smaller than either taxes due as a result of a lifetime gift, and significantly smaller than the costs of a formal probate, it can still be an inconvenience or an impossibility for people with modest estates (or who find themselves “house rich but cash poor”) who want to be sure that their assets are made available to their children when no longer needed by the original owners.
5. Grantor Trust. A “grantor trust” is a planning device typically used where Medi-Cal planning is a significant part of the estate plan; it allows the original owner of the house to transfer the house to a trust, which moves it out of the owner’s estate from Medi-Cal’s perspective, but retains it in the owner’s estate from the point of view of the IRS and state courts enforcing creditors’ rights, which allows favorable tax treatment for recipients and keeps the house out of reach of the children’s creditors until the owner passes away. Unfortunately, grantor trusts are sophisticated planning devices and their cost (while much less than the cost of nursing home care) dissuades many people who might otherwise benefit from their use.

In contrast to these alternatives, a beneficiary deed seems like a simple alternative, especially for small, simple estates, where clients don’t want or need the comprehensive planning that’s possible with a trust-based estate plan. Beneficiary deeds allow owners to specify the disposition of their property at death while preserving favorable tax treatment and avoiding the risks of divorce, business failure, or bankruptcy caused by hospital or other overwhelming bills. While I’m aware that many estate planning attorneys oppose the introduction of beneficiary deeds to California, I believe that they’d provide significant benefits to many people with limited resources, who realistically are unwilling or unable to take advantage of more advanced planning techniques and are otherwise forced to use last-resort approaches such as joint tenancy or lifetime gifts.

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