Tax Benefits Stay with Life Estate Owner

Will your taxes change if you make a gift of real estate subject to a life estate over a straight gift of real estate? Guest blogger  Stacey Crowell Maiden, Esq., Of Counsel to our Trusts and Estates and Elder Law Practice Group provides an explanation of this common, but non-intuitive planning technique.

In our estate planning and elder law practice, we sometimes incorporate the use of a “Life Estate Deed” to transfer real property.. Under a Life Estate Deed, the “life tenant” retains 100% of the present interest of the property. The future interest (which is defined as the full interest after your death) would be transferred to the “remainder persons.” When retaining a Life Estate in the property, you are not transferring or giving the entire interest in the property away. Instead, the remainder persons are given today the right to own the property after you pass away.

The life tenant is responsible for the payment of real estate taxes on the property. However, the Municipal Tax Office - on receiving a copy of the recorded Life Estate Deed from the County Clerk – will update its records, listing the remainder persons as the owners, which means the tax bills are then sent in the names of the remainder persons. This can be a source of confusion and concern for our clients, particularly as to whether they will lose any tax benefits related to ownership.

Guidance is found in the Internal Revenue Code and Regulations, New Jersey Statutes and the New Jersey Administrative Code to assure our clients that as life tenants, they continue to receive certain tax benefits provided to owners in New Jersey.

For example, life tenants retain the Income Tax Deduction for Real Estate Taxes. As the owner of the property by virtue of the life estate, a life tenant may continue to deduct the real estate taxes he pays on his federal income tax return. (I.R.C. §164(a); Reg. §1.164-1(a).

And, by reserving a Life Estate and paying the real estate taxes, the life tenant is entitled to continue to receive the New Jersey Homestead/New Jersey Saver Rebate (N.J.S.A. 54:4-8.58; 54:4-8.58a; 54:8.59); the Senior Citizen's Deduction (N.J.A.C. 18:14-1.1 and N.J.A.C. 18:14-2.8); and the Veteran's Deduction (N.J.A.C. 18:27-2.10).

Of course, there are other potential taxes (e.g. capital gains taxes) to be concerned with when transferring property pursuant to a Life Estate Deed, but the above tax benefits related to present ownership of the property remain in place for a life tenant who pays the real estate taxes.

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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.