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.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.
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