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Amortization of life estates and term interests.

A term interest in property is defined under Sec. 1001(e)(2} to fitclude a life interest in property, an interest in property/or a term of years and an income interest in a trust.

When a term fitterest in property is created, there may be an opportunity to write oil the cost of the interest even if the property is not otherwise depreciable. When the underlying property is depreciable, the term holder may be able to accomplish a faster write-off of its cost than would be available under normal depreciation rules. However, if the term holder and the remainderman are related, special rules may apply to deny this amortization entirely and impose an odd set of basis calculation rules.

Prior to the Revenue Reconciliation Act of 1989, any purchaser of a term interest could amortize the cost of his interest over his life expectancy or the term of years of the interest on a straight-line basis. However, an individual who divided an existing property and kept a term interest could not amortize the retained interest. Example 1: A and B are unrelated individuals who purchase a $100,000 security. A purchases a 10-year interest in the security for $60,000 and B contributes $40,000 for the remainder interest. A may offset his income from the security by $6,000 of amortization of cost each year. After the term interest has expired, B succeeds to the property with a basis of $40,000; this amount may not be amortized but is B's basis for purposes of computing gain or loss on disposition. If A dies during his term leaving unamortized basis, the remaining unamortized basis is lost.

In Example 1, if the underlying property is depreciable, there is a twist. A conservative approach would be for the term holder to depreciate the basis in the remainder at the same time he is amortizing his interest. An aggressive approach would be to depreciate the entire cost of the property and amortize the term interest all at the same time [up to the property's total cost).

While these rules continue to apply to property interests created between unrelated parties, the rules have been modified when the term holder and the remainderman are related. For such term interests acquired or created after July 27, 1989 in tax years ending after that date, Sec. 167(e) provides that no amortization of the term interest is allowed. Instead, a calculation of the amortization is made on an "as if" basis. The amortization, while not a deduction to the term holder, becomes an addition to the remainderman's basis. In the example, if A and B were related, A's amortization of $6,000 per year would have been added to B's basis for purposes of determining gain or loss for for depreciation purposes if the property was depreciable). For depreciable property, the depreciation deduction is taken on 100% of the property as if the term holder owned the entire interest. The remainderman's basis adjustment is made for his percentage interest in the property plus the disallowed amortization using a modified calculation.

Example 2: Assume the same facts as in Example 1, except that the property is a depreciable commercial building whose depreciation deduction each year amounts to $3,150, and that A and B are related. The depreciation deduction is used entirely by A each year to offset his income from the property. However, for basis purposes, 60% of the depreciation reduces A's life estate cost such that after year 1, the remaining cost is $58,110. The "as if" amortization deduction is 10% of that amount or $5,811. B's basis is $44,551 at the end of the year; this amount represents his original $40,000 cost reduced by $1,260 (40% of the depreciation of $3,150) and increased by the $5,811 of "as if" life estate amortization. Each year thereafter, the amortizable life estate for purposes of the "as if" calculation is made after reduction of the basis by 60% of the depreciation allowed for the year divided by the number of years remaining in the term. Assuming the term holder lives beyond the expiration of the term interest, B will succeed to a depreciable asset. His basis at that time for all purposes ought to be the original cost of the entire property less 100% of the depreciation taken.

For purposes of these rules, related parties are defined in See. 267[b) and [e), and generally include spouses, linear descendants and siblings. Also, an individual and certain entities in which that individual has more than a 50% ownership interest are related. Special rules apply if the remainderman is a tax-exempt entity, nonresident individual or a foreign corporation whose income is derived from a trade or business outside the United States.

These new rules go hand in hand with the new estate freeze valuation rules of Sees. 27012704. Many of those popular estate planning techniques that are still available or that have become available after the new rules would be too good to be true without the changes made to Sec. 167.

From Susan L. Bezzarro, MT, CPA, Cohen & Company, Youngstown, Ohio
COPYRIGHT 1992 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Bezzarro, Susan L.
Publication:The Tax Adviser
Date:Aug 1, 1992
Words:861
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