Transferring the personal residence: income and transfer tax planning issues for the older client.

Planning for an elderly client often involves either the immediate or potential transfer of the client's personal residence. The process also often includes considerations other than estate and income tax issues, such as longterm health care (including the potential for nursing home care).

Many methods have been developed to successfully transfer the residence to one's heirs, while at the same time reducing real estate/income tax liabilities.

As is typically true, however, no one method will necessarily accomplish all a client's goals. Instead, the potential results of various methods must be compared in terms of each client's particular situation.

Transfer to spouse

For some clients, it is advantageous for only one spouse to own the residence. For example, an ill or incapacitated spouse may want to transfer the house outright to the healthy spouse for purposes of Medicaid eligibility and/or protection.

If the property is transferred from one spouse to the other, there are no gift tax consequences; Sec. 1041 exempts transfers between spouses from transfer tax. In addition, the transferee spouse will get a carryover tax basis for income tax purposes (Sec. 1015(e)). When the transferee spouse dies, his heirs will get a stepped-up basis in the residence because the residence will be included in his estate (Sec. 1014).

A transfer between spouses preserves the income tax benefits of Sec. 1034 (deferral of gain) and Sec. 121 (the $125,000 exclusion) for the transferee spouse if the residence is sold during the transferee's lifetime.

Transfer to children (or others)

Sometimes a client does not have the option of making a transfer to a spouse, possibly because of death, divorce or the potential incapacity of both spouses. Transfers to others can be achieved by either outright transfers, creation of a joint tenancy, a retained life estate or a retained right to occupy the premises rent free. Trusts may also be helpful in these situations.

In addition to the estate/ income tax results to be considered, a planner must also keep in mind other relevant, nontax issues-such as protection from the transferee's creditors, the possibility of the sale of the property in the near term and the trustworthiness and "good faith" of the transferee(s).

An outright transfer results in a carryover basis for the transferees, with no step-up at the transferor's death (Sec. 1015). In addition, when the transferees sell the house, they will not be entitled to either the deferral of gain (Sec. 1034) or the lifetime exclusion (Sec. 121) (unless they personally use the property as their principal residence).

In addition, although the transfer will keep the residence from being included in the transferor's estate, a gift tax return must be filed when the property is transferred and a portion of the transferor's lifetime exclusion used, based on the property's fair market value (FMV). Although simple, this option is ordinarily not an attractive one, especially when the residence has a low tax basis and is highly appreciated.

The creation of a joint tenancy results in a carryover basis for the new joint tenant's portion and exclusion of half of the residence's value from the transferor's estate. But it requires gift tax reporting just as in the case of an outright transfer.

In addition, the new joint tenant will not be eligible to use the income tax deferrals or exclusions discussed for his portion if the property is sold, unless he occupies the residence. In many cases, a joint tenancy is not a desirable choice for elderly clients because their child may predecease them, thus creating the need for an additional transfer at a later date.

Gift of a remainder interest (a retained life estate) allows a homeowner to transfer a remainder interest in a house while retaining many of the tax benefits conferred on homeowners, and at the same time minimizing the gift tax consequences.

In this case, the homeowner transfers the home by simple deed to his heirs subject to a life estate. This will allow the application of Sec. 1014(b)(9), which allows the heirs to take the property with a stepped-up basis equal to its FMV at the lime of the life tenant's death if the life tenant retains his interest in the property at death (Sec. 2036). Because the retained life estate has a value based on the IRS actuarial tables (see Notice 89-60), the present value of the heir's future interest is sharply reduced for gift tax purposes. The older the life tenant, the smaller the value of the life estate.

If the homeowner wishes to sell the residence, he must obtain permission from the remaindermen. In addition, although the income tax benefits of the $125,000 exclusion and the deferral of gain under Sec. 1034 are still available to the homeowner, the sales proceeds must be allocated between him (as the life tenant) and the remaindermen (based on IRS actuarial tables). Thus, gain could be recognized by the transferor during his lifetime.

An outright transfer with a retained right to occupy rent free is similar in some respects to a transfer of a life estate. The property will be included in the transferor's estate because he has retained control over the property. Thus, the heirs get a stepped-up basis under Sec. 2036(a). However, since the title is no longer in the transferor's name, the income tax benefits of Secs. 1034 and 121 are lost.

Transfers to trusts include the most popular-the qualified personal residence grantor retained income trust (GRIT). (A full discussion of this type of trust is clearly beyond the scope of this item.) In terms of the estate/income tax issues being discussed, the creation of a personal residence GRIT allows the transferor to reduce the value of his current gift (since the value of the remainder is reduced by the right to income over the trust term) and exclude the residence from his taxable estate, if the requirements of Sec. 2702(a)(3)(a)(ii) and other conditions are met.

Also, because the trust is considered a grantor trust, rollover treatment and the $125,000 exclusion should be available if the residence is sold.

As this summary plainly shows, planning for the transfer of the personal residence of an elderly client offers a myriad of choices and considerations. In many instances, a chart that lists choices and variables should be developed in order to determine a recommendation. An attorney should always be consulted so that legal issues are addressed. In addition, it cannot be overemphasized that the client must be an integral part of the planning process from the beginning in order for a plan to be successfully implemented.