Tax & Business Insights

Taxation of Life Estates

Volume 25 Issue 2 --March/April 2013

In many states, life estates in residences are a common estate planning tool. Sometimes they are used for Medicaid planning purposes, as well as to avoid having property pass through probate.

In the typical arrangement, by deed a parent transfers her residence to her children reserving the right to live in the property for the rest of her life. The children receive full use of the property after the parent  dies (sometimes called a “remainder” interest).

While this may seem like a simple transaction, the tax consequences can be surprising.

To put this in a context, suppose that in April, 2010 Lilly (age 70) deeded her home to her children, Sam and Diane, reserving the right to live in her home for the rest of her life.  The home was then worth $300,000, and Lilly had a basis of $50,000 in the property.

Usually, the life tenant (Lilly here) must pay all of the expenses associated with the property and is entitled to any income earned while the life estate is in existence but has no say in the disposition of the property.

Did Lilly make a completed gift? In most cases, unless Lilly retains the right to control the disposition of the property she will have made a completed gift for gift tax purposes.

Because the gift to the children is of a “future interest,” the annual gift tax exclusion will not apply and a gift tax return is required. But what is the value of the gift?

What has been transferred to Sam and Diane is the remainder interest — full ownership and use of the property after Lilly dies. The value of this interest must be determined by use of IRS actuarial tables based on the currently applicable § 7520 interest rate. The relevant table here is Table S in IRS Publication 1457.

For example, when Lilly created the life estate deed in April 2010, the applicable  § 7520 interest rate was 3.2%. According to the actuarial tables, Lilly’s life estate represented 34.320% of the value of the property while the remainder interest of Sam and Diane was 65.680%. To determine the value of the gift, multiply the remainder  factor times the fair market value of the property. Here, this means that the value of the gift to Sam and Diane is $197,040.

If the property were something other than Lilly’s personal residence, a different set of rules may come into play, but we will ignore those rules here.

The same allocation used to determine the value of the gift also applies to allocate the basis between Lilly and Sam and Diane, since Sam and Diane receive a carry-over basis in the gift. After the gift, Sam and Diane’s interest has a basis of $32,840 (65.680% of the $50,000 basis) while Lilly has a basis of $17,160 in her life estate. At least until Lilly dies, these basis figures control future income tax consequences.

For example, suppose that 3 years later, in April, 2013, Lilly can no longer stay in her home and as a result she, Sam and Diane sell the entire property to an unrelated third person for $350,000.

At that point, because Lilly is older (73) the value of her life estate is smaller. In April 2013, the applicable § 7520 interest rate is also lower, 1.4%. If the sales proceeds were divided in accordance with the relative values of Lilly as shown in the actuarial tables, Sam and Diane should receive 84.651% of the $350,000 or $296,279, while Lilly should receive $53,721.

In that situation, Lilly would have gain of $36,651 ($53,721 - $17,160). If Lilly meets the requirements of IRC § 121 for her principal residence, she can exclude all of the gain. 

Sam and Diane, however, cannot elect to exclude their share of the gain, unless they are also living in the property and meet the § 121 requirements.  If not, they will have taxable gain equal to $296,279 - $32,840 = $263,439.

If, however, the property is not sold before Lilly dies, then a different set of factors comes into play.

Despite the fact that Lilly’s transfer of the remainder interest in the property is a completed gift for gift tax purposes, the entire value of the property is included in Lilly’s gross estate for estate tax purposes, because she transferred property and retained an interest for her life. This means that the property is subject to a step-up in basis to the fair market value of the property on the date of Lilly’s death.

If Sam and Diane sell the entire property after Lilly’s death, their basis will be the fair market value of the property on the date of Lilly’s death.

If you have questions about the tax aspects of life estates please call the Tax & Business Professionals.

Copyright 2013
By Tax and Business Professionals, Inc.
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