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Cake and Ice Cream, Too: Tax Ramifications of the Life Estate

By Peter Stern, Esq


We all know that the transfer of a remainder interest and retention of a life estate is a safe haven for recovery avoid- ance and getting that step up in basis. As Have Your Cake and Eat It Too: Part Deux—The New Tax Act (Net News, Spring 2011) made clear, we’re back to a step up in basis mode, since the retention of the life estate keeps the prop- erty in the taxable estate of the decedent under IRC Section 2036. Our recovery regulations, at 22 CCR 50961 (i) and (j), clearly put remainder interests and other irrevocably transferred interests beyond the grasp of estate recovery.

The rest of this article can best be understood by using a hypo: our imaginary “old parent,” whom I will call Irene, has one child, a daughter, Margaret. Irene’s house in San Francisco has an assessed value of $500,000 and a fair market value of $1,200,000. Margaret could care less about the house or recovery avoidance. She wants what’s best for her aging mom, but Irene is devoted to her daughter and wants to be sure that when she goes into long term care, she will qualify for Medi Cal and not have to have the house be subject to recovery. Irene navigates her way through a very stressful job, to which she is devoted, but as she ages, her doctors have told her she may have a debilitating illness in the next few years.

Should Irene do anything with the house right now? I’d advise her to keep the house in her name (it’s in her living trust), but I would also review her general durable power of attorney and the trust and consider doing a new power of attorney with explicit language that would allow Margaret, who is the attorney in fact, to remove the house from the trust if Irene goes to long term care and a doctor asserts in writing that Irene is likely to stay there for more than three months, and then to gift a remainder interest in the house, using the power of attorney, and to retain a life estate for Irene.

Should Irene be worried that the adoption of the DRA regu- lations, at some indefinite point in the future, might hamper her ability to transfer the house? No. The equity value of the house is under the California cap of $750,000 plus the cola adjustment, and the house remains unambiguously exempt and will continue to be so under any of the DRA permuta- tions we can reasonably expect. The exempt residence can be transferred with no penalty in the future.

Let’s assume that with the passage of time, Irene, now age 80, is now in a nursing home and can no longer exercise judgment or carry out transactions. She is on the Medi-Cal program. Margaret, using the power of attorney, removes the house from the trust and deeds out the remainder inter- est to herself (the power of attorney permits this self deal- ing) and reserves a life estate for her mother.

Gift Tax Issues

The value of the gift is the value of a remainder interest for a person who is 80 years old.

Irene will have to file a Form 709. The Form 709 instructions require valuation of the transferred interest at fair market value. Federal methodology for determining the value of remainder interests can be found in 26 CFR 20-2031.7 and will require using the prevailing 7520 rate and tables from publication 1457. But no tax is due, since Irene has given away far less than her lifetime cap.

Although we do not know what the gift threshold will be after 2012, it is hardly likely to be less than the value of Irene’s house, and no tax will be due. [Very few of my clients actually file gift tax returns after making a transfer of this nature, because they are not going to have to file estate tax returns. Nevertheless, I always counsel them to file the return.]

Income Tax Issues

Irene has retained a life estate, and she is entitled to all of the rents and profits from the house. She will continue to file income tax returns (Margaret will no doubt file them using the power of attorney and a Federal Form 2848 power of attorney), and if Margaret converts the property to a rental, Irene will still file a Schedule E showing the rental income less the costs of the property (taxes, insurance, mainte- nance and repairs). How will the net income be treated for Medi-Cal share of cost purposes? Under 22 CCR 50508, the net income will be part of Irene’s share of cost.

Is there an alternative? Margaret is content to have her mom’s net income defray nursing home costs and ease up on the amount the state will have to pay each month. But some of my clients want to deflect as much as possible of the income to others. One alternative is to make the life estate a right to occupy but not a right to income. This alternative can be part of the conveyance deed. If the client chooses this income, the income is taxable to the holder of the remainder interest.

Estate Tax Issues

IRC Section 2036 is back in place; property in which a dece- dent had reserved a life estate comes back into the estate for estate tax purposes, and under newly revived Section 1014 gets a full step up in basis. The valuation of the property for estate tax purposes, if Irene’s estate warrants the filing of a 706, would be the combined value of the life estate and the remainder interest. But it’s hardly likely that Irene will have a taxable estate. What she does get, of course, is a full step up in basis, and if Margaret now wants to sell the house and move to southern California, she can do so without having to pay capital gains tax.

(Peter S. Stern, Esq., is an attorney in private practice in Palo Alto, CA)