While the title may initially suggest a discussion about a child who “fails to launch,” becomes a lifelong dependent of mom and dad, and never leaves the basement, the intended focus of this blog is much broader. Feel free to remove the mental image of the stereotypical 37-year-old unemployed son playing Xbox in the basement with crushed aluminum cans, empty pizza boxes, potato chip bags, and the proverbial glass hash pipe scattered across the coffee table.
The situation I seek to discuss can encompass a wide variety of family circumstances in which aging parents seek to account for a child who is currently living in their home for reasons such as the child’s health or personal issues, assistance with caring for the parents, cultural norms, financial considerations, or many other legitimate reasons. Throughout this blog, I may refer to this individual as the “basement child.”
This commonly includes situations where a child and the child’s spouse sell their own home and invest substantial funds into a parent’s residence to create a reverse “in-law suite” arrangement. Parents often come to me and ask how they should address and account for these circumstances in their estate planning.
This blog discusses ways to create clarity and structure surrounding these arrangements in order to reduce confusion and prevent conflict during estate administration.
Defining the Arrangement
The first step in incorporating this type of arrangement into an estate plan is defining exactly what the arrangement means.
Oftentimes, I must press clients for a more precise explanation regarding the purpose and expectations surrounding the situation. Unfortunately, many parents do not seek legal advice until after a child has already invested substantial money into the home. At that point, the central question becomes: what exactly was the agreement or expectation?
Was the child’s investment intended to be consideration for rent-free housing? Will the child be contributing to utilities, taxes, insurance, maintenance, or other housing expenses? Was the investment made in exchange for future caretaking services as the parents age? Was there an understanding that the child would eventually inherit the home or have the right to remain there?
If the arrangement can be clearly defined, it is generally wise to formalize it through written documentation. If the arrangement has never been clearly discussed, it is important for the parent and child to initiate that conversation as soon as possible.
Even when those discussions occur, however, the question still remains: how should the arrangement be addressed within the estate plan itself?
Life Estates and Buy-Out Provisions
One common desire expressed by parents is that they want the basement child to “be able to stay in the home” or “have the home if they want it.” While I understand the sentiment, those intentions are often vague and can become problematic without careful planning.
Part of the difficulty is that clients are planning for future circumstances that may look very different from the present. Most clients do not expect to pass away in the immediate future, and family dynamics, financial circumstances, and housing situations can change dramatically over time.
Two of the most common options discussed in these situations are life estates and buy-out provisions.
A life estate is generally the more extreme option. A life estate grants the beneficiary an exclusive possessory interest in the property for the duration of the beneficiary’s lifetime unless the interest is voluntarily released sooner. The creation of a life estate effectively splits ownership between the life tenant and the remainder beneficiaries, who receive ownership upon the death of the life tenant.
While life estates can accomplish certain goals, they can also create disputes and significantly complicate the title, transferability, and financing of the property for many years or even decades.
A simpler and often more practical option is providing the basement child with a first right to purchase the property from the estate or from the other siblings at fair market value.
Although these matters can sometimes be resolved informally among siblings, there is no guaranteed legal right for one child to buy out the other beneficiaries after the parents’ deaths absent specific planning documents providing for such a right. Instead, siblings must often agree on how to handle inherited real estate. While many siblings may willingly agree to sell their interests to the basement child, there are situations in which siblings instead prefer to list the property for sale in hopes of maximizing financial return. There can also be competing desires among multiple children to acquire the property.
One relatively straightforward solution is to include a detailed first-right-of-purchase provision outlining the appraisal process, valuation method, deadlines, financing requirements, and procedures by which the basement child may exercise the purchase right.
While such provisions can be included in a Will, buy-out provisions are often easier to administer and create fewer title complications when implemented through a Living Trust.
This option can work particularly well when the basement child may also inherit liquid assets that can be used to fund the purchase through a relatively quick and efficient cash transaction.
In addition, estate planning documents should address how prior investments into the property will be treated.
Should those investments operate as a credit or offset against the purchase price the basement child must pay? Should the investments instead be considered fully repaid through years of rent-free housing? Should the investments be treated as loans or debts owed by the estate? Was a promissory note executed? Was a deed of trust or lien recorded against the property?
The key is to clearly document both the background of the arrangement and the parents’ intent within the estate planning documents and related agreements.
Leaving the Homeplace to the Child with Equalization Provisions
In some situations, parents may wish to leave the homeplace outright to the basement child while still ensuring an equal overall distribution among all children.
In many cases, however, this simply is not financially feasible. This approach only works when the anticipated value of the homeplace at the parents’ deaths is equal to or less than the expected share the child would otherwise receive from the total estate.
Estate planning necessarily involves attempting to predict future asset values based upon present information. In many respects, this is partly an educated guessing exercise regarding the future value of the homeplace compared to the remaining estate. Nevertheless, during the later stages of life, particularly when clients are in their 60s, 70s, and 80s, it is often possible to make relatively accurate projections.
Sometimes the issue is obvious. For example, if parents in their late 70s live in a $1.5 million home while the remainder of the estate consists of approximately $250,000 in investments and a few vehicles worth less than $20,000 collectively, it will likely be impossible to equalize the estate between two children if one child is to receive the homeplace outright.
Conversely, if the figures are reversed, such as a $250,000 home and $1.5 million in investments and accounts, equalization becomes much more achievable.
How exactly should equalization be structured?
Clients often want to specify fixed dollar amounts within their estate planning documents. However, that is frequently not the ideal approach because both real estate values and investment assets fluctuate over time.
Instead, the better practice is usually to include provisions requiring equalization while carefully defining the formula and process used to calculate the equalization amount. This often involves requiring an appraisal of the homeplace as of the date of death or another specified valuation date.
There can also be complicated implementation issues arising from how assets are titled and designated.
Many clients assume that their Executor will control all estate assets after death. In reality, that is often not the case. In the modern era, many individuals designate direct beneficiaries on retirement accounts, investment accounts, annuities, and life insurance policies. As a result, the Executor may not have sufficient probate assets available to properly effectuate equalization among beneficiaries.
To address this issue, careful planning is often required. In many situations, a Living Trust is the most effective planning tool. In other cases, careful beneficiary designation planning and periodic review may be sufficient.
Summary
When a child moves into a parent’s home, it is important to consider expectations and potential estate planning implications as early as possible.
Ideally, families should consult with an estate planning attorney before substantial investments or renovations to the property occur. Defining the arrangement first, and then structuring the estate plan around that arrangement, is critical to avoiding disputes and confusion later.
These situations frequently increase the complexity of the estate plan and often make Living Trust-based planning particularly beneficial if a trust is not already part of the overall estate plan.
Andrew M. Brower is a Board Certified Specialist in Estate Planning & Probate Law at Law Firm Carolinas, which has five offices and a statewide practice. For questions about estate planning and administration, wills and trusts, guardianships, or Medicaid/long-term care and asset protection, contact Law Firm Carolinas.