Wednesday, August 1, 2018

Life Estate/Remainder Arrangements and Income Tax Basis

Overview

Naming one person to receive the income and/or use of property until death and naming another person to receive ultimate ownership of the property is done for various reasons.  One primary reason is to allow one person (or persons) to have the use of property during life and then have someone else own the property after the life estate expires. Life estate/remainder arrangements are also used for estate tax planning purposes.  In that instance, the intent of the person creating the life estate/remainder arrangement is to effectively use the estate tax exemptions of both the husband and wife.

The life estate/remainder arrangement also raises some tax issues.  One of those issues concerns the income tax basis of the property that is the subject of the arrangement. The cost basis of inherited property is almost always the fair market value of the property as of the testator's date of death. However, what is the income tax basis of property when the various rights to the property are not owned by the same people?

Income tax basis issues associated with property subject to a life estate/remainder arrangement.  That’s the subject of today’s post.

Basis Issues

The general rule is that property is valued in a decedent’s gross estate at its fair market value as of the date of the decedent’s death. I.R.C. §1014.  It is that fair market value that determines the basis of the property in the hands of the recipient of the property.  That’s fairly simple to understand when the decedent owns the entire property interest at death.  However, that’s not the case with property that is held under a life estate/remainder arrangement.  In that situation, the remainder holder does not benefit from the property until the life tenant dies.  That complicates the income tax basis computation. 

Uniform basis.  The general idea of uniform basis is that the cost basis of inherited property should equal the value used for estate tax purposes.  The new cost basis after death is usually referred to as the “stepped-up” basis, although the new basis can be lower than the original cost.  As noted above, it’s tied to the property’s fair market value as of the date of death for purposes of inclusion in the decedent’s estate.  The regulations state that the basis of property acquired from a decedent is uniform in the hands of every person having an interest in the property.  Treas. Reg. §1.1014-4. As explained in the regulations, under the laws governing transfers from decedents, all ownership interests relate to the death of the decedent, whether the interests are vested or contingent.  That means that there is a common acquisition date and a common basis for life tenants and remainder holders.

The uniform basis rule is easy to implement after the death of the life tenant, as shown in the following example.

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Example. Boris leaves his entire estate to his son, Rocky, as a remainder holder. However, all income from the estate is payable to his wife, Natasha, until her death. The value of the property is $200,000 at the time of his death.

Natasha collects the income from the inherited property for 20 years. When she dies, the appreciated value of the property is $500,000.

When Natasha dies, Rocky becomes the sole owner of both the property and the future income. However, because Rocky's ownership of the property is based initially on his father's death, Rocky's basis is $200,000 - the value at the time his father died.

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The result of the example makes sense when you consider that the value of the life estate interest is excluded from Natasha’s estate.  Because it was excluded from her estate, there is not basis step-up in Rocky’s hands – the person who receives the right to the income after Natasha dies. 

If the inherited property is subject to depreciation, the holder of the life interest is allowed to claim the depreciation expense attributable to the entire inherited basis of the depreciable property.

Sale of the Life Estate Interest

The basis rules change dramatically for the holder of a life estate interest if the rights to the income are sold without the remainder interest being sold as part of the same transaction. If the life interest is sold separately, the seller's basis for tax purposes is $0.  I.R.C. 1001(e).  The buyer of the life interest can amortize the cost of the purchase over the life expectancy of the seller.

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Example.  Bill leaves a life interest in stock to his neighbor, Dale, and a remainder interest to another neighbor, Bobbi. The value of the stock for estate tax purposes is $5,000 at the time Bill dies. Dale immediately sells his life interest to LuAnn for $100.

Dale's cost basis in his life interest is $0. Dale reports the gain of $100 on Schedule D, Capital Gains and Losses, as a long-term capital gain.  I.R.C. §1223(10).  This transaction has no effect on the uniform basis. The cost basis allocable to Bobbi's remainder interest will continue to increase each year as the life interest's value decreases. Treas Reg. §1-1014.  LuAnn is entitled to subtract a portion of the $100 she paid Dale each year against her dividend income. The subtraction is based upon Dale's life expectancy at the time of the sale.  Treas. Reg. 1.1014-5(c).

Technically, there is no authority directing LuAnn where.to include this subtraction on her return. The conservative approach is to include it in investment expense on Schedule A, Itemized Deductions. An aggressive approach is to treat it in the same way as premiums paid for bonds, which is as a subtraction on Schedule B, Interest and Ordinary Dividends.

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Death of the Remainder Holder

If the holder of the remainder interest dies before the holder of the life interest, the uniform basis is not adjusted and the life tenant's basis is still calculated as explained previously.

However, the value of the remainder interest is included in the estate of the remainder holder. The regulations, therefore, allow the beneficiary of the remainder holder's estate to adjust the basis for a portion of the value that is included in the estate.

This basis adjustment is calculated by subtracting the portion of the uniform basis allocable to the decedent immediately prior to death from the value of the remainder interest included in the estate.

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Example.   Marge died in 2006. In her will, she left Bart, her son, a life estate interest in their family home. She left Lisa, her daughter, the remainder interest. In 2010, Lisa died.  In Lisa's will, Maggie, her sister, is the sole heir. Bart is still alive.

The fair market value of the house in 2006 when Marge died was $100,000. At the time of Lisa's death, her share in the uniform basis was $15,000, based on Bart's life expectancy and the fair market value. The value of the home in 2010 when Lisa died was $200,000. The value of the remainder interest included in Lisa's estate was $30,000.

Maggie's basis adjustment in the inherited house is shown below:

Value of the house included in Lisa's estate

$30,000

Less: Lisa's portion of the uniform basis at her death

(15,000)

Maggie's basis adjustment in the house

$15,000

When the beneficiary to the remainder interest sells the property, the basis is calculated using the beneficiary's current portion of the uniform basis at the time of the sale plus the adjustment.

Conclusion

Most people have a pretty good understanding that the income tax basis of property received from a decedent that was included in that decedent’s estate is the fair market value of the property as of the date of the decedent’s death. But, the basis issue becomes more complex when the property at issue is part of a life estate/remainder arrangement.  It’s a common estate planning technique, so the issue often arises. Hopefully, today’s post helped sort it out.

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