Tax Implications of Life Estate Transactions

Following our recent seminar we got a general question about the income tax implications of entering into a life estate transaction in which a person gifts the remainder interest in his personal residence and retain a life estate.  The question was as follows:  If the person gifts the remainder interest now but later sell the house, will the property owners owe capital gains tax upon the sale?

This question requires an examination of a handful of general principles:

1.  If a person owns his residence and has met the IRS’ occupancy requirements over the previous 5 years, that person can sell his residence and not pay any capital gains tax (up to a certain ceiling);

2.  A gift of appreciated property (the remainder interest in this case) gives carry-over basis in the property to the gift recipient (and will likely trigger gift tax reporting issues, although under the current rules, gift tax would likely not be due given high exemptions);

3.  The gift of the remainder interest separates ownership into 2 different groups of owners (life estate owner and remainder interest owner), meaning, the house can no longer be sold during the life estate owner’s lifetime without capital gains tax implications; and

4.  Notwithstanding the carryover basis rule mentioned above, if a person retains an interest in property at the time of death (retention of a life estate in this case), the IRS will give a step-up in basis to the remainderperson because the entire value of the property (both life estate and remainder interest) would be part of the taxable estate for calculation purposes – tax actually owed is a separate matter.

 What’s the take-away from the above rules?  A gift of a life estate can sometimes be a useful tool to accomplish certain planning goals.  However, if it’s likely that the house will be sold in the near future, the best person to sell the house is a person who owns the entire interest and meets the residency requirement, meaning, it’d be better to sell without doing the life estate deal.  If the life estate transaction has already been done, and if the house had to be sold, it’d be better to wait until after the date of death of the life estate holder because the step-up in basis would wipe out the capital gain issue again.  The least desirable scenario is to enter in to the life estate transaction and then be forced to sell the entire property during the lifetime of the life estate owner because that would very likely trigger capital gains being due (assuming a low basis in the house being carried over to the remainderperson).  Note that we’re talking about selling the entire interest, not having the remainderperson purchase the life estate as part of a Medicaid eligibility plan.

There are several concepts working together here, but it’s useful to think through them all when contemplating working with life estates.

Mark Coriell

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