Life Estates - Estate Tax and Inheritance Tax Consequences

Life estates are commonly used in elder law asset protection planning.  Mom owns a house worth $400,000.  She gives the house to her children(a "remainder interest"), and keeps the right to live in the house during her lifetime (a "life estate interest").  The gift of the remainder interest is "transfer" for Medicaid purposes, and starts the clock on the 5 year lookback period.  

The gift of the house subject to a life estate is a popular asset protection planning technique because it is easy to understand and less invasive to lifestyle than other transfer techniques. Making a gift of a remainder interest simply involves the attorney preparing a deed and associated real estate transfer documents.  There are no realty transfer tax consequences - realty transfer tax is not assessed in New Jersey for transfers without consideration (i.e.: a gift). Also, using a life estate technique not much changes from a practical perspective as the life estate holder (ie: Mom) continues to be responsible for all property taxes, maintenance and upkeep - and is still entitled to the Senior property tax rebate.  Perhaps most importantly, you don't spend your house, so it is emotionally easier to give away an interest in a house than to give away cash dollars that you may still want to spend.  For those who think they are at least 5 years away from a nursing home, a transfer of a house subject to a life estate can be a home run as the house tends to be the most valuable single asset.

But what happens from a tax perspective when the owner dies? (Assuming the death is not in 2010 when we have no federal estate tax - see my prior post on estate tax implications for deaths in 2010)

If you give away an asset and keep a life estate in that asset, the life estate acts like a "string" that pulls 100% of the value of the asset into your taxable estate.  From an estate tax perspective, this mean that (1) 100% of the value of the house is included in decedents taxable estate, and (2) the cost basis of the house is "stepped-up" to the value of the house on date of death (IRC 2036).  So, if Mom bought the house for $40,000 and it is now worth $440,000, Mom's estate includes the house valued at $440,000, and kids get the house with a $440,000 basis.  When they sell the house for $450,000 down the road, then they only have $10,000 of capital gain.  The $400,000 of appreciation that occurred during Mom's lifetime essentially disappears (you potentially pay estate tax instead).  If the total estate is less than $675,000 (New Jersey) or $1,000,000 (federal starting in 2011 - unless congress changes it), then there will be no estate tax due.  If there is a New Jersey estate tax, the rate ranges up to 16% on amounts over $675,000 - this is far less than the capital gains tax (15% federal plus 7.5% NJ) on $400,000 if Mom simply gave the house to the kids without keeping the life estate.  

In New Jersey we also need to contend with the Inheritance Tax if the remainder beneficiaries are not children - for example, Aunt gives her house to her nieces and nephews and retains a life estate.  The Inheritance Tax is a separate tax from the estate tax that is assessed against a beneficiary based on their relationship to the decedents - transfers to spouses and children are exempt, transfers to other family members are not.  For example, when Aunt dies, the life estate acts to make 100% of the value of the house subject to inheritance tax (NJAC 18:26-5 et seq).  So, nieces and nephews get the house, but they need pay an inheritance tax at the rate of 15%-16% with no exemption.  The inheritance tax is a credit to the estate tax, so you don't end up paying both taxes if the estate is subject to estate tax and the beneficiaries are not children or spouses.

The benefits of making  a transfer of a house subject to a life estate can significantly outweigh any estate tax or inheritance consequences in many situations.  The key is to get advise for YOUR situation to see if transfer of a house subject to a lift estate make sense to protect your assets from a Medicaid spend-down.

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Comments (6) Read through and enter the discussion with the form at the end
Ohio personal injury lawyer - March 13, 2010 2:10 AM

Very interesting blog. I would definitely put you on my favorites list.

Jan - June 21, 2010 1:09 PM

My mother-in-law SOLD us her house in NJ. She wants a life estate so she can live there till she dies. We have no problem with her living there, but we already own the house. I also don't want a document she can sell or give to anyone else. I want her to be comfortable and live there until she dies or goes in a nursing home - I don't want other relatives moving in with her. What do you recommend?

kelly henderson - July 11, 2010 9:58 PM

We used this tool over 5 years ago for asset protection. My parents transferred the house to me (their daughter) and took back a life estate. Since then, my father has died and mom is still living (95). She no longer needs the life estate (as she has moved into an assited living facility. Cash is running low and the house may need to be sold to net some cash for her living expenses. Is there any way for me to sell the house now without incurring the capital gains tax?

Diane Rossi - September 23, 2010 8:41 AM

My mother's house was placed in a life estate over 5 years ago. We have since sold that house and purchased an apartment in another state. We use the rental income to help supplement her income and pay for her assisted living.
I have a question - must all the rental income go to my mother? The question relates to qualifying for medicaid , with the rental income she will never qualify for medicaid even after we spend down all her other assets.

Maureen - October 25, 2010 3:07 PM

is there a way to minimize estate taxes & /or inheritance tax implication to nieces and nephews upon aunt's death (in her will & assuming estate is >675K)?

alden hammer - April 8, 2012 3:59 PM

my wife past away the house is in her name she had living trust giving me the husband life time estate can i rent the house or do i have to live there alden

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