How Quitclaim Deeds Can Cause Estate Planning Catastrophes

Editor’s note: This is part two of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. Part one is To Avoid Probate, Use Trusts for Estate Planning.

Deeds must be used to transfer real estate into an LLC or into a trust, making deeds an essential part of implementing most estate plans. However, deeds should not be used in lieu of trusts, because deeds will cause many unanticipated consequences and even harmful legal and tax consequences.

Quitclaim deeds are a deceptively simple power tool — they are usually only one or two pages and appear simple to fill out — so why hire a lawyer? As a first point, many people don’t even know how to pronounce the phrase “quitclaim deeds” and call them “quick claim deeds.” Ironically, “quick claim” is a speciously apt nickname for quitclaim deeds because quitclaim deeds in fact do “quickly” quit all claims to the property. Mistaken names aside, what could go wrong with doing a little legal work yourself using a quitclaim deed as a power tool?

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Using a quitclaim deed alone as a tool to avoid probate (or anyone else for that matter) is pretty much always a terrible idea. The following is an example (which I wish were fiction) outlining the pitfalls of the successor beneficiary to real property skipping the probate process by using deeds:

Example. A child inheriting real estate from their parent doesn’t want to deal with probate, so they skip the probate process and simply file a quitclaim deed transferring the real estate of their deceased parent to themself without going through the probate process. The county recorder records the deed, giving the illusion that all is well. The child even begins to pay the annual property taxes.

Later, the child who is now on the deed lists the real estate for sale, and a buyer makes a good offer that the child accepts. During the real estate due diligence process, the title company discovers that the property was transferred without probate as required under the state’s real estate laws. The title company calls the child beneficiary and tells them that they do not have marketable title to the real estate property because no title insurance company will issue a title policy without probate closing orders.

This is a rude awakening for the beneficiary child because the home sale is then stalled, the prospective buyer demands their money back, and the real estate sale dies, pending probate.

Perils of not using a trust instead

Sometimes a person planning for their estate will transfer real property to a child ahead of time. The following is an unfortunate example (which I wish were fiction) illustrating one of the many calamities caused by trying to avoid probate and accomplish estate planning objectives using quitclaim deeds instead of trusts:

Example. A parent who owns real estate gets creative trying to avoid probate and to save trust formation legal fees, so they quitclaim deed a property to a child or list their child’s name on a property as a “joint tenant with rights of survivorship.” The child who is named on the deed later has a “mishap” — the mishap could be a business meltdown, bankruptcy, car accident or divorce. After the mishap, the child’s judgment creditors run an asset search and discover the child’s name on the parent’s real estate as joint owner of the real property. The child’s creditors foreclose on the child’s stake in the joint real property, and the parent loses half of their real estate to their child’s creditors.

By quitclaim deeding to the child or putting the child’s name on the property, the real estate owner becomes subject to the creditors of their child. An additional problem caused by naming another owner on the real estate deed is that the homeowners or other property insurance can become ineffective due to insurable interest issues. Insurance companies must be notified if a new owner is added onto a property. Otherwise, how else can the insurance carrier assess its risks and know to whom the insurance is payable? To prevent this “vicarious liability” and property insurance risk, the real estate owner should have formed a trust and transferred the property into the trust rather than using a quitclaim deed.

Even if no lawsuit or mishap occurs — even if the child added onto the deed is an absolute angel and nothing bad will ever happen — by quitclaiming the title of real estate to a new owner, an additional title insurance problem will automatically result. To show the automatic title insurance problems that result from quitclaim deeding a home, consider this scenario:

Example. A parent quitclaim deeds a home to their child to avoid probate and avoid the costs of setting up a trust. Later, the parent goes to sell their real estate and discovers that the title insurance policy is rendered ineffective due to the quitclaim deed. The parent is forced to repurchase an expensive title insurance policy so they can sell the home.

No one loves buying title insurance, and most property owners would prefer not to unknowingly throw out that expensive title insurance, which is like burning a stack of hundred-dollar bills.

Other issues when naming a child on a deed

Unfortunately, the title insurance waste isn’t the last problem from using deeds as estate planning legal power tools. Some additional financial issues are caused by naming a child on a deed for a property. Naming a child on a deed subject to a mortgage is nearly always a violation of the due-on-sale clause in the mortgage note or deed of trust, which could entitle the bank or private equity group holding the mortgage to force an expensive refinance after the transfer.

Beyond that, once a child is named on a deed to real property, the real property becomes an asset for the child, which must be disclosed on any application requiring financial reporting. The following illustrates an additional issue in finance that I have encountered in my law practice:

Example. A grandparent lists their child on a quitclaim deed to their property, and then a grandchild files an application for federal student aid. Because the grandchild’s parent is listed on the property deed, they are legally an owner of the grandparent’s property. Consequently, the grandchild’s parent must list the property as an asset on the grandchild’s application for federal student aid. However, most often the family still thinks of the home as belonging to the grandparent even though they are legally required to report the property. When the grandchild forgets to report their parent’s ownership of the home, the student and their family have inadvertently committed loan fraud.

As if the vicarious liability risks, insurance issues and the financial reporting parade of horrors resulting from deeding real estate isn’t enough, on top of all these problems, putting the child’s name on the deed is a reportable transaction to the IRS, requiring that a gift tax return be filed.

Even worse, when the child one day sells the home (or if the home is lost to a child’s creditor), the child will need to pay much more capital gains taxes on the property once they sell it.

The tax consequences of blithely using quitclaim deeds are startlingly rapid, non-obvious and very painful — very few people expect that by quitclaiming to their child, the child will need to pay capital gains taxes that could have been avoided by instead using a trust that results in a “step-up in basis” to the value at the time of death.

A worst-case scenario

Example. A homeowner wants to avoid “complicated” estate planning and comes up with the idea of transferring their house (purchased many decades ago) to their children using a quitclaim deed. The oldest of the homeowner’s children is disabled and needs to apply for Medicaid, but Medicaid denies the application because the child owns one-third of the home — a valuable asset. The homeowner’s middle child is the power of attorney and finds out that the homeowner failed to report the gift of the home to the IRS on Form 709, a gift tax return, and learns that the failure to report the gift is a misdemeanor.

The homeowner’s youngest child has a student in college applying for federal financial aid, but the youngest child doesn’t think about their one-third interest in the home and fails to report the asset on the college loan application — a felony.

After the homeowner dies, the three children list the home for sale, and the title company informs the children that they will need to repurchase an expensive title insurance policy because the quitclaim deed filed by their parent “quit” the old title policy. After the home sale closes and the three children receive the home sale proceeds, the children each receive a Form 1099-S, unexpectedly reporting that each child will owe capital gains taxes on $1 million of gain. This is because the homeowner’s low basis (homeowner’s purchase price plus improvements) in the home transferred to the children through the gift of the home rather than the home qualifying for a step-up in basis to the value at the time of the homeowner’s death.

The three children speak with a tax attorney before paying the $288,000 in capital gains taxes, assuming the maximum federal capital gains tax rate of 20%, plus net investment income tax of 3.8%, plus a 5% state-level capital gains tax. The children are unpleasantly surprised to learn that if the homeowner would have simply deeded the home into a trust for the children, instead of using the quitclaim deed, capital gains taxes would have been $0.

The capital gains taxation result of permanently transferring property with low basis to another person or trust is startling to many people, so it is worth considering another simpler example to highlight the dramatic consequence.

Example. A parent purchased land for $100,000 and made no improvements to the land, and now the land is worth $1 million. The parent’s “basis” in the land is their purchase price of $100,000, and now that the land has appreciated to a value of $1 million, the parent has $900,000 of “built-in gains.” If the parent quickly quitclaim deeds the land to their child, which has the legal effect of transferring the parent’s basis of $100,000 in the $1 million land, the child will owe $288,000 in state and federal taxes (based on the previous example assumptions) once the child sells the land. If the parent had instead transferred the home to the child through a revocable trust, which includes the land in the parent’s gross estate (even if no estate tax is owed), the child would owe $0 in capital gain taxes.

In short, deeds are legal power tools, and putting another person on the title of real estate will nearly always cause a mess of vicarious liability, insurance failure and financial reporting problems and cause both gift tax and capital gains tax problems. This is why I often counsel clients that, with real property deeds, “DIY results in DYI” (doing it yourself results in doing yourself in).

Don’t name anyone on the deed of your home unless you love burning your cash, risking your real estate and unwittingly committing loan fraud and enjoy paying lots of unnecessary taxes. Prevent many problems by using a trust to leave property rather than using deeds.

My next article will cover the estate planning benefits of revocable trusts.

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• IRS Quietly Changed the Rules on Your Children’s Inheritance
• Cut Your Wealth Transfer Taxes With a Family Limited Partnership