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TRANSFERS WITH A RETAINED LIFE ESTATE PART TWO: ESTATE TAX.

Editor's Note: This is the second in a two-part series discussing the planning opportunities afforded by deed transfers with a retained life estate. The first part ran last month.

Viewed solely as a tax-saving transaction, a deed transfer with a retained life estate is of questionable benefit. The primary benefit of deed transfers of real property with retained life estates appears to be the protection of assets. Substantial benefits from a deed transfer with a retained life estate may be achieved, however, for the individual whose primary concern is the protection of assets against the cost of long-term nursing home care.

The use of a transfer with a retained life estate has been a common planning device for years. In many cases, a taxpayer will resist the recommendation, because of the normal desire to hold onto one's assets. In some cases, this hesitation can be overcome by using a transfer that guarantees by contract the transferor's right to continue to use the property after the transfer for a specified period of time or remaining lifetime.

Example

Mr. and Mrs. Tobias own a home jointly, purchased 40 years ago for $30,000. Since the date of purchase, they have made improvements to the property totaling $25,000. The home is worth $325,000 in today's market, and the mortgage was paid off long ago. The couple has two children, both married, living nearby. Both husband and wife are retired, age 72, and in good health. They have other assets totaling $1.2 million, including a stock and bond portfolio, personal property, and insurance. They have started to focus on their estate planning but are concerned that they will outlive their financial resources.

Estate Tax Aspects

If Mr. or Mrs. Tobias should die while still holding a life estate in the transferred property, IRC section 2036 would include the full fair market value of the property in the gross estate. For section 2036(a) to apply to a transaction, the transfer must be for less than full and adequate consideration, the transferor has to retain an interest in the property, and that interest must exist at the time of death or for a period not ascertainable without reference to such death. The transfer of the Tobiases' residence with a life estate would meet all these requirements.

If both the transferred property and the life estate are in joint name, section 2040(b) would seem to require only one-half of the value of the life estate to be included in the estate of the first spouse to die [regulations have never been issued for Sec. 2040(b)]. In a 1966 ruling [U.S. v. Heasty, 370 F2d 525 (10th Cir. 1966)], the court treated jointly held property as inducible in the first spouse's estate to the extent of only one-half because state law gave the surviving spouse rights to one-half. Because of the subsequent provisions in section 2040(b), the inclusion of one-half of the property should prevail in current situations. With the application of the unlimited marital deduction, however, the surviving spouse may benefit from the inclusion of 100% of the jointly held asset because of the resulting stepped-up basis. For joint property interests created prior to 1977, Gallenstein v. United States (975 F2d 286) could allow for the inclusion of 100% of the jointly held asset in the first spouse's e state if that spouse contributed all of its purchase price. This would result in a full step-up in basis.

When IRC section 2036 operates to include the property subject to the life estate in the gross estate of the transferor, the value of that property is determined as of the date of death (unless the executor has made an alternate valuation date election). The value as of the date of the original transfer, used in the gift tax return, is not pertinent to the estate tax filing. If the transferor received any consideration upon the original transfer, it will reduce the amount of the includible asset for estate tax purposes.

The inclusion of the asset's value in the transferor's estate will cause the same asset to be taxed twice for transfer tax purposes. To mitigate this, the amount of "adjusted taxable gifts" included in the calculation of estate tax will be reduced by the original gift amount.

In the event that Mr. or Mrs. Tobias wanted to make an inter vivos transfer of their life estate to their children, the transfer would preclude the estate tax inclusion under section 2036 because the life estate was not held at the time of death. In order to prevent deathbed transfers designed to avoid the estate tax, section 2035(a) calls for the estate inclusion of any property interest transferred during the three years preceding death that would have been includible under section 2036 if it had not been transferred.

Income Tax Aspects

Once the remainder interest in the property has been transferred by gift, both the donors and the recipients will have income tax issues. The first question for any donee is, "What is my basis in this property?" The starting point in this calculation is the adjusted uniform basis of the property immediately before the donor gifts it. In the Tobiases' case, they have an adjusted basis in the property of $55,000. The separate bases of the life estate and the remainder interest are determined by the factors found in section 7520. If the property included in the life estate is depreciable, the holder should be aware of section 167(e), which treats any term interest as non-depreciable if the remainder interest is held, directly or indirectly, by a related person.

The majority of life estates will run until the life tenants die, in which case the remaindermen will succeed to the entire interest in the property. Because section 2036 will cause the property to be included in the transferors taxable estate (but not the probate estate), the basis of the property in the hands of the remaindermen will be the basis derived from the estate. Subsequent dispositions of the property will use the estate value to determine gain or loss on the disposition.

Lifetime dispositions of either the term interest or the remainder interest before the transferor dies presents some interesting basis issues. If Mr. and Mrs. Tobias wish to dispose of their life estates prior to their deaths, their basis in the property will be determined under the general rule referred to above: they will measure gain or loss from the portion of their adjusted basis, calculated at the time of gifting. The adjusted basis of the total property at the time of gift ($55,000) is multiplied by the section 7520 factor for valuing a life estate for two persons, both age 72, AFR of 7.6% (.30695). To measure their gain or loss on the sale, they use the resulting basis of $16,882. If the sale occurred prior to May 7, 1997, it would be eligible for the principal residence exclusion under the old version of section 121; the current rules, however, are less clear. The sale of the remainder interest would appear to qualify for the section 121 exclusion if both the ownership and use tests are met and the sale is to an unrelated party. The sale of the life estate would apparently not qualify for such exclusion. When the regulations under this provision are finally promulgated, they may clarify this issue.

If the holder of the remainder interest desires to sell it, the gain or loss computation is relatively simple. The basis is disregarded when the property being transferred represents only a portion of the entire property interest and was acquired by gift or bequest. The only exception to this rule is when all of the interests in the property are sold at the same time.

The good news is that Mr. and Mrs. Tobias will be able to deduct the real estate taxes paid on their residence. If the transferred property had a mortgage, the deductibility of the interest paid would depend upon the form of the property transfer. If the property were transferred subject to an existing mortgage with no assumption of the liability by the remaindermen, the transferor (life tenant) would remain liable for the debt. Because the life tenants also have an equitable interest in the property, the regulations should allow the interest deduction if they actually make the payments. At the same time, one could argue that the remaindermen should be allowed to take the deduction if they make the payments, even if they are not liable on the mortgage.

Planning Opportunities

One of the most common uses of a deed transfer with a retained life estate is to protect the residence against the high cost of long-term nursing home care.

Assume different facts: that the Tobiases have only $3,750 of assets in addition to their residence and that their residence is located in Suffolk County, N.Y. With a residence valued at $325,000, the Tobiases are not concerned with gift taxes or estate taxes. Instead, their objective is to reside in their home as long as possible and leave it to their children. Should the Tobiases require nursing home care, they are at risk of losing their residence to pay for it. A deed transfer of their residence with retained life estates of the Tobiases may save their house.

Medicaid is available to pay for the cost of long-term nursing home care for applicants whose non-exempt assets fall below certain amounts (presently $3,750). A house is an exempt asset provided it is used as the primary residence for the Medicaid applicant, certain family members, or both. The Tobiases' residence, presently an exempt asset, would lose its exemption when it ceases to be used as their primary residence. If the Tobiases do nothing until they require nursing home care, the house will lose its exempt status and they will not be eligible for Medicaid because the value of the residence ($325,000) will be available to pay the nursing home costs. If, however, the Tobiases transfer their residence to their children while retaining life estates, they will qualify for Medicaid benefits (subject to any penalty period, as discussed below) because the value of the life estate is not an asset for Medicaid eligibility purposes.

The Tobiases should not wait until they need care before effecting the transfer, because if the transfer of their residence by deed is made within three years of the application for Medicaid benefits (other than certain exempt transfers beyond the scope of this, article), a "penalty period" of time would result, during which the Tobiases will not be eligible for Medicaid benefits. The penalty period is determined by dividing the value of the assets transferred by the average regional nursing home rate in the applicant's county ($8,125 in Suffolk County, N.Y.) to reach a number of months of Medicaid ineligibility. The penalty period commences on the first day of the calendar month following the month of the transfer. In this example, $325,000 divided by $8,125 results in a penalty period of 40 months. Because the penalty period is greater than three years, the Tobiases can limit their penalty period to three years by not applying for Medicaid benefits until the three-year period has expired.

Unlike the gift tax treatment for deed transfers with retained life estates, the Medicaid rules allow a discount for the value of a retained life estate. The Department of Health and Human Services Health Care Financing Administration (HCFA) has established tables that specify the value of life interests and remainder interests based upon the age of the transferor. For a 72-year-old transferor, the value of a remainder interest is 42.739%. Thus, the Tobiases' penalty period for the transfer in our example is calculated by multiplying $325,000 by 42.739% and dividing that result ($138,902) by $8,125, yielding a penalty period of 17.1 months.

Should the Tobiases require nursing home care after the penalty period has expired, Medicaid will pay the cost of such care. During the time that the Tobiases are in a nursing home and while they still hold a life estate, their children may rent out the residence and use any net rental income to pay the cost of nursing home care. Because Medicaid can only recover the nursing home costs it paid from a recipient's probate estate, upon the Tobiases' death the house will pass to their children with no recovery or reimbursement to Medicaid.

As discussed above, the house will be included in the Tobiases' taxable estates and the basis of the house will be its fair market value on the date of the death of the second transferor. Holding the property until the deaths of both Mr. and Mrs. Tobias can avoid all capital gains; however, if the house is sold during their lifetimes, the value of the life estate at time of sale will be available to pay the cost of nursing home care and, as seen above, there may be a loss of the section 121 exclusion.

A deed transfer with a retained life estate may also be used to avoid probate. The owners retain exclusive use of the property during their lifetimes, and the property passes to the designated remaindermen upon their death. The cost of probate may be avoided, although the beneficial use of the property does not change until the deaths of the owners. This may be useful when an individual owns property in more than one state.

Another possible reason to use this form of transfer is that the taxpayers feel that they have made a lifetime gift without depriving themselves of an asset that they might need as they get older. Financial planning of any type must also address the psychological factors that affect individuals.

In terms of possible alternatives, the taxpayers may consider transferring the property to a revocable trust. This transfer would not produce any exposure to transfer taxes because it would not constitute a completed gift. Because the decedent would have complete control over the property, it would be included in the taxable estate but not in the probate estate, offering some limited protection from estate creditors.

At first glance, a QPRT might also make sense, because the gift tax exposure is limited to the actuarially computed value of the remainder interest under section 7520. The problem with a QPRT is that if the transferors outlive the trust (generally the desired result), the property will pass automatically to the trust beneficiaries. The transferors would then have to vacate their residence or negotiate a lease arrangement. Many older taxpayers are not comfortable with the possibility of eviction if they cannot achieve an agreement on manageable terms.

Robert E. Bertucelli, CFP, CLU, CPA, is a professor of accounting and taxation at the CW Post Center of Long Island University and a partner of Bertucelli & Malaga, LLP, Hauppauge, N.Y. He was this year's recipient of the Emanuel Saxe Award as the Outstanding CPA in Education. Richard A. Weinblatt, Esq., CPA, is a partner of Haley Weinblatt & Calcagni, LLP and co-chair of the Elder Law Committee of the Suffolk County Bar Association.
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Author:Bertucelli, Robert E.; Weinblatt, Richard A.
Publication:The CPA Journal
Geographic Code:1USA
Date:Jul 1, 2001
Words:2537
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