You Inherited Property, What Comes Next?
Emotions and real estate: you can’t have one without the other.
Inheriting property has many layers of sentimental value. It may be important to keep grandma’s house or grandpa’s farm in the family and passed down for generations. But for beneficiaries of inherited property, it is much more complicated than that.
While using the home as a personal residence may be the best way to maintain the sentimental value, adding in insurance, titles, taxes, and other family member’s opinions can make this process difficult and challenging both financially and emotionally. There are many moving pieces to consider when you inherit property and today our team will outline a few different things to keep in mind as you and your family navigate this process.
Consider the costs
Before you make any decisions, it is important that you know all the costs associated with this inheritance. Let’s start with the price tag you are all thinking about, the mortgage. It is important to know that one can’t inherit a mortgage, per se.
Rather the property is considered encumbered, or it still retains mortgage or other peripheral debt. Once the property goes through the estate proceedings, this debt would have to be satisfied either paid in full, sold, or refinanced prior to any settlement. Why does it work like this? Well, the mortgage company is technically a creditor of the estate, making it the responsibility of the estate’s executor to handle before anything is finalized.
If the property is unencumbered (breathe a sigh of relief) the beneficiary will want to obtain a few different documents pertaining to the property:
Appraisal (understand the home’s value)
Taxable cost basis (used for future tax reporting)
Title (the state of the property i.e encumbered or unencumbered)
In a perfect world, the executor of the estate would discuss potential distribution options with the beneficiaries before any decisions were made. Today, we are going to live in that perfect world and walk you through the three overarching options beneficiaries have after inheriting property including the advantages and disadvantages for each:
Let’s get started.
Options if you want to move in
For some beneficiaries, moving into the inherited property makes the most sense. This process is much simpler if you are the sole beneficiary of the property and don’t have siblings or other co-owners to negotiate with. But before you start celebrating your new house, keep a few things in mind:
- Your mortgage
- Property taxes
- Inspection/The current state of the property
How much work would it be to move into this property? Will your property taxes increase? Does the house need a lot of work to be livable for you and your family? Does it make sense location-wise for your job or kid’s school? These are just a few questions to consider before adding a new set of keys to your collection.
If you are inheriting property with multiple people, you have a couple of different courses of action to consider. First, you can elect to buy-out the other co-owners. You can do this by taking out a mortgage for the buy-out value and any additional amounts to cover improvements or upgrades you want to make. You’ll also want to keep property taxes and insurance payments at the front of your mind should you choose this option.
Let’s say the buy-out idea doesn’t sit well with other beneficiaries, trust us this happens all the time, the other option you have is to accept co-ownership. If you and your fellow beneficiaries decide to do this, we recommend treating it like a business. Oftentimes co-ownership gets murky and complicated with confusion over bills, liabilities, and other expenses getting in the way.
We recommend that you create an entity like a Limited Liability Partnership to clear the air and provide a platform for managing liability, expenses, and profits. This requires strong legal counsel to get right but it can really help navigate the challenges of multiple owners should you choose to go down that path. Your legal team can also help create an operating agreement that would outline things like management structure and buyout parameters.
Pro tip: With multiple beneficiaries, the best-case scenario is to have one resulting owner with the others receiving other assets like cash in lieu of the property itself. This is just something to keep in mind as you are creating your own estate plan.
Of course, insurance planning should be done before the transfer of title so that the property is never unprotected. It is also wise to get property tax vouchers or have a clear idea of the tax responsibilities before it transitions from the estate to any heirs.
Client case studies—A Family Matter
A prime example of this situation happened when we worked with a husband and wife client team that had several lake properties. This ended up being a delicate situation that involved re-working property boundaries in addition to making improvements and repairs to provide equal lakefront property for the three sibling beneficiaries. We also obtained appraisals so that between the property value itself and cash, equal values were transferred to each branch of the family.
Another example occurred when we worked with a client who owned a tri-plex that was placed in a corporation when he moved to a nursing home. Shares of the company were transferred overtime to start transitioning ownership to children and grandchildren. Having the bank serve as a mediator when controversy arose provided necessary transparency and ultimately allowed the family to be in business together but also remain close.
We handled the day to day payment of bills, recurring taxes and insurance, and negotiated leases. When the client passed, we continued management until the property was ultimately sold. There were tax advantages as well as interpersonal family benefits as a result.
Use the property as an investment
If you aren’t using the inherited property as your personal residence, it becomes an investment vehicle. It will be wise to incorporate it into your investment portfolio to complement your other holdings as well as prioritizing long-term planning and strategy. When you do this, ask yourself a few questions:
What is a reasonable rate of return on the property?
Is the underlying value expected to appreciate? If so, how long will that take?
Do you have funds to cover short-term rental expenses like cleaning, handy work, etc.?
Are you prepared to assume property taxes and other insurance costs?
Does your property comply with local planning and zoning laws?
You probably didn’t know that there were so many things to think about when renting property but being a landlord comes with many unique challenges.
For one, you will need to have a highly liquid account to cover expenses if something breaks or if there is a lull in the rental market. You may also need to make some cosmetic updates or improvements to make your listing more attractive to renters which could cost you upfront capital.
You will also need to decide if you want to manage the property yourself or hire a management company. These companies often take 20-30% of your profits which makes your margins slimmer but also frees you from the 2 am phone call when the water heater breaks. Another important part of running a successful rental is finding the right tenants.
Finding a good tenant is vital—one that won’t abuse the property and is reliable with rent and utility payments. While you can use the services of a collection agency or turn to eviction in the case of a bad tenant, these processes are costly both in time and money. With the right tenant, you will be able to maintain the quality of the property and have a reliable source of income.
When you are a landlord, always use a formal lease contract that outlines both the owner and the tenant’s responsibilities including payments and timelines. You can also request a deposit for any damage to be returned at the end of the lease if the property is still in good condition. This provides you with legal protection. You can also request a credit history from prospective tenants, rental history, and current employment to get a sense of if the tenant will be a good fit for you.
It is also important that you keep accurate and thorough records. All expenses related to recurring taxes, insurance, maintenance, and repairs are tax-deductible, thereby offsetting income.
Perhaps the most straightforward option that beneficiaries have is to sell the property and use the proceeds as an inheritance. Keep in mind that the house will need to be unencumbered, meaning free of debt, before the title can be transferred to the new buyer. This means that mortgage debt, tax responsibilities, and insurance payments will need to be satisfied before the sale.
Most estate property is sold as-is and the executor can sell it without making property disclosures so if that is the plan from the beginning, you can ask the executor to market and sell the property and distribute cash as an inheritance.
Before selling, you’ll also want to ensure that the property is up to code and in good shape. If it’s not, you run the risk of buyers asking for your participation in meeting certain loan standards that could eat into your profits.
You’ll also need to think about the taxes you will need to pay after you sell. You will get the benefit of selling inherited property at a better tax rate—the difference between the inherited tax basis and the selling price will be taxed at capital gains rates, which are currently capped at 20%. If you made any repairs to prepare the property for sale, this can reduce your tax liability, so be sure to keep good records and share those with your tax preparer.
First Dakota can help
Our team has worked with many families in transitioning property and it is a sensitive subject for sure! Allowing an independent, third-party professional to assist and facilitate can help broker peace while also moving the process along at a steady pace. Ultimately, this can maintain family harmony which is a priceless thing, especially where estate planning and inheritances are concerned.
First Dakota National Bank’s Wealth & Trust Officers are trained to understand the complexities related to property and can add significant value from emotional support to strategic tax planning to superb record keeping to keep the process as smooth as possible. We would love to talk to you about any planning or logistical challenges related to real property and are happy to partner with you to find the best solutions for your situation. Give us a call today.
First Dakota Wealth & Trust is the fiduciary investment department of First Dakota National Bank with trustee powers to serve clients during their lifetime, during incapacity and after death. We help clients develop a financial roadmap to help simplify their financial future.
Please note that neither First Dakota National Bank nor First Dakota Wealth & Trust, or its employees provide tax or legal advice. This is intended for informational purposes and is not intended to constitute legal or tax advice. Please consult your attorney and/or tax professional for advice related to your specific situation.