Inherited rental home - keep in irrevocable trust? change to a new revocable trust? Tax pros and cons?

[klma]

Hello, when my mom passed away in 2014,  my grandmother's house (which mom inherited in 2011), went into an Irrevocable bypass trust with income for the benefit of my dad, but listing me as the beneficiary.  We turned the home into a rental home. My Dad recently passed away (August, 2020) and I need to figure out the next steps with this house.  I want to keep it and rent it out still. Eventually I'd like one or both of my children to inherit the home.

What are my options and the tax ramifications of each option?  Here's how I see it...

1.  Keep the home in the irrevocable bypass trust "forever." If I do this then each year I will have to move the income from the rental home to me to put on my taxes.  I will need to complete a 1041 each year for the trust.  If I do it this way then do I never need another grant deed?  It would always just stay the same but the beneficiaries would change??  The cons that I see to keeping it in the bypass trust are having to complete the 1041 and not getting a step up in basis when I pass it on to my kids someday.  The pros that I see are that since the irrevocable trust owns the house it'll be easier for my kids someday to "joint own" it - or at least jointly benefit from the rental income. It would be protected from their assets if either of my kids were to be divorced... and if it passes down to their kids it would be much easier, I'd think, for the irrevocable trust to continue to own the house for the benefit of all the grandkids as beneficiaries.  But then if one of the grandkids wanted to sell the house they probably couldn't do so without all grandkids agreeing, right?  And can I be the trustee of the irrevocable trust as well as the beneficiary?  I'm meeting with the attorney who created the irrevocable trust tomorrow so I'm hoping he can offer some insight on these questions.  Maybe the grant deed would have to change every time there was a trustee change?

2. From what I read I can also pull the house out of the irrevocable trust and create my own Revocable Trust with the house and other assets.  Pro's would be not having to do a 1041 and house would "step up" in basis when I died.  Cons - when I die my two kids (both in their 20's) would be listed as joint owners on the deed.  And then if one of them dies then their kids would be added on and there would be more and more owners of the house which could get very messy.

3. Just put the house in my name and let it go through probate to my kids someday. Either way I'm paying to go through probate or paying for an attorney to draft another trust....

Another critical piece of information... this house is in California.  As long as we pass the house from parent to child we maintain the original tax basis (thanks to Proposition 13). However, if Proposition 19 passes in November then the next time it passes hands it will be taxed at present value.

Thanks for your help!!

[Carl]

As long as we pass the house from parent to child we maintain the original tax basis

Please confirm that I"m right here.

You only maintain the original *PROPERTY* tax basis. This has nothing to do with the *COST* basis of the property when it comes to figuring taxable gain, should you sell the property. Am I correct?

[mellish7777]

Your understanding seems right in all 3 examples you gave and it's up to you to decide what's best for your family's configuration and situation. Major issues are as you described: stepped up basis....probate....beneficiaries agreement on how to deal with the property.

An individual can be trustee and beneficiary of a trust at the same time so that's not a problem and if the title is in the name of the trust you don't have to change it each time there is a new trustee but pulling the property out of the trust is an option only if the trust permits that. You should run all of the issues by your attorney and if that person is not knowledgeable in the tax issues get a referral to a tax pro.

[Carl]

Also, from what I see at https://www.californiataxdata.com/pdf/Prop13.pdf prop 13 does *NOT* seem to address inheritance. On the federal side, if you inherit a rental property, then you get a step-up in *COST* basis to the FMV of the property on the date the prior owner passed away. Prop 13 doesn't seem to address this. (Not addressing Prop 19 at this time, but I'm not ignoring it.)

From what I read Proposition 13 replaced the practice of annually reassessing property at market value with a system based on cost at acquisition. If you inherited the property, then you have "no" cost of acquisition. Therefore I assume you also "inherit" the original property tax basis. Is that assumption correct? I suspect not. Would be helpful if you could refer me to a more complete document on Prop 13.

[mellish7777]

Don't you understand the CA issue? I guess you don't. It's got NOTHING to do with inheritance at all....it's got EVERYTHING to do with property taxes that could increase a ton but not if the property is passed from parent to child unless Prop 19 is passed.

[Carl]

Don't you understand the CA issue?

Nope, and since I don't live in CA or own property in CA, I really don't need to. But from what I see Prop 13 and Prop 19 only deal with *Property* taxes, and have absolutely nothing to do with any other taxes, such as capital gains on the sale of the property. But leaving the property in a trust may have negative ramifications in the future for all I know. If I recall correctly, when it comes to income tax, I think that taxes on a trust can be higher than taxes on an individual. I know that estate taxes can be higher than personal taxes. But not to sure on that when it comes to trusts.

Overall, so long as the property remains in the trust, I "may" (not sure) retain it's original cost basis and not get the step-up in basis. That can be a real killer on the tax liability when the property is sold.

[mellish7777]

There are pros and cons to leaving the rental in a trust and the person who started this conversation is aware of them or appears to be. The reason taxes can be more in a trust is because the rates are compacted so you get to a higher rate quicker than individuals do. Still trusts are flow throughs so those higher taxes can be avoided by distributing the income and gains to the individual benes. There won't be a further step-up in basis if the property remains in the trust but the trustee is aware of that and there has been a ton of talk in D.C. about getting rid of the step-up altogether anyway so in the long term you shouldn't be counting it as a given.

[Critter-3]

I highly recommend you seek local professional assistance with this and other tax planning matters instead of relying on this nameless, faceless public forum.  The trust papers need to be read to see what it will allow.