A life-estate deed is a legal arrangement commonly used to transfer a home (or other real property) upon a person’s death. Typically, both the “giver” and the “recipient(s)” need to be listed on the property’s deed. The “giver,” who is also known as the “life tenant,” retains the property during their lifetime. When the life tenant dies, the property passes automatically to the designated recipients, who are also known as the “remaindermen” or “remainder owner(s).” While life-estate deeds are often used because they are relatively easy, allow for automatic transfer of property at death, and avoid probate and (most) estate taxes, there are some tax issues at the time of creation of the life-estate deed and after the death of the life tenant.
Before Death of Life Tenant/Giver
There are few tax consequences when the life-estate deed is created:
· Property taxes - The life tenant is responsible for all property taxes while they are still alive.
· Possible tax breaks for the life tenant - Creating a life estate may enable the life tenant to enjoy certain tax breaks such as reduced homestead or senior tax exemptions.
· Annual gift tax exemption – Depending on the value of the property and the number of years that a life tenant expects to live, a life tenant can use their annual gift tax exemption ($15,000, as of 2020) to make a tax-free gift to the remainder owners. For example, if the sale price of a home is $150,000, a $15,000 tax-free gift can be given annually for the next 10 years to eliminate potential tax liability for the remainder owners.
After Death of Life Tenant/Giver
Upon the death of the life tenant, the home automatically transfers to the remainder owner(s). While probate and most estate taxes are avoided, there are tax consequences for the deceased life tenant and remainder owners:
· Individual Tax Liability - When the life tenant dies, their ownership of the home passes to the remainder owner listed on the deed. The amount of tax the life tenant pays on their last individual tax return is based on the fair market value (FMV) of the property. The individual tax liability for the deceased life tenant is thus based on the difference in price between the home’s original purchase price and its FMV at the time of death. This is typically a significant capital gain that would need to be reported on Schedule D (Capital Gains and Losses) of the deceased life tenant’s tax return.
· Possible capital gains tax advantage for remainder owner – After the death of the life tenant, the remainder owners can usually live in the home as a residence and claim homestead exemption on the property. If the remainder owners sell the home without living in it, any gain on the stepped-up basis (readjustment of the value of an asset whose worth has gone up for tax purposes upon inheritance) is taxed by the IRS as a capital gain. The tax basis in the home is its FMV at the time of death, which generally results in an advantage for the remainder owners. Had the giving homeowner instead donated the home to their heir while they were still alive, the recipient’s tax basis would be calculated at the time of the donation.
In other words, with a life-estate deed, the remainder owner’s tax basis is the value of the home at the time of the life tenant’s death, which is usually a higher value and thereby reduces or eliminates capital gains tax consequences with a future sale of the property. For example, if the deceased life tenant purchased the home for $50,000 originally (and put $50,000 of improvements into it over the years), the tax basis would be $100,000 if they simply donated the home to their heir. If instead a life-estate deed is created and the home has a FMV of $500,000 at the time of death, if the remainder owners sell the home for $500,000, they would have no capital gains tax liability from the sale, as opposed to having to report a $400,000 capital gain otherwise.
· Estate Tax Liability – While a life estate does not go through probate, the IRS treats the life estate transfer as a sale, and the FMV of the house is included in the estate. If the estate exceeds the exclusion amount, the deceased life tenant’s estate could owe taxes on the difference. As of 2020, the estate exclusion amount is $11,580,000. Any excess amount is taxed using a graduated tax scale (18% to 40% marginal tax rate, depending on the excess amount).
· Possible federal gift tax consequences. The remainder owners may need to claim the life estate property as a gift subject to federal gift tax if the value of the remainder interest is greater than the annual federal gift exemption.