Life estates are estate-planning tools used to facilitate the transfer of real property, such as a personal residence, to heirs by keeping the property out of the probate process. You create a life estate by adding your heir or heirs to the deed as the remainder owner. As the life tenant, you remain responsible for paying all the costs and enjoy all benefits of the house. When you pass away, the remainder owner receives clear title to the property.
Creation of the Life Estates
Life estates, if held until the death of the life tenant, count as part of the decedent’s estate. Because life estates protect the life tenant’s right to use the property, tax law typically treats the transfer as inheritance rather than a gift, but under certain circumstances, you may still need to report the discounted value of your property as a gift on the appropriate forms. If you're transferring a personal residence, you generally don't owe any gift tax on your annual return.
Income Tax on Sale for Life Tenant
Selling a property owned in a life estate requires all owners, life tenant and remainder owner, to sign. Typically, Section 121 provides a generous exemption for gain from the sale of a personal residence. Establishing a life estate generally keeps the Section 121 exemption available to the life tenant, but not for the remainder owner. Tax law requires that life tenants and remainder owners recognize their proportion of the gain according to an allocation based on the age of the life tenant and an interest rate set by the IRS.
Income Tax on Sale for Remainder Owner
The remainder owner doesn't get to offset any gain from the sale of the life estate with the Section 121 exemption. Instead, she must pay capital gains taxes on her portion of the gain from the sale. For example, a property sells for a $100,000 gain, and IRS Table S allocates 13 percent to the life tenant and 87 percent to the remainder owner, the remainder owner must report capital gains of $87,000. That results in a tax bill of at least $13,050 before taking state taxes into account.
Because life estates contribute to the taxable estate of the life tenant, the remainder owner receives a step up in basis when the life tenant dies. For example, if the life tenant paid $35,000 for the property plus improvements and the property is worth $350,000 on the death of the life tenant, the remainder owner acquires the property with a basis of $350,000. On the other hand, if the life estate sells prior to the life tenant passing away, the original cost basis determines the taxable gain to be allocated between the two parties. In the same example, the estate sells for $350,000 before the life tenant passes away, the life tenant and remainder owner must split $315,000 in gain. Renting the property until the life tenant passes away provides both income to the life tenant and the step up in basis for the remainder owner.
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