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Life Estate Can Be Retained for Estate Tax Purposes Without Being Reserved in Deed, and Result in a Step-up in Basis for Capital Gains Tax Purposes

Estate Tax Inclusion Results in a Step-Up in Basis and Eliminates Capital Gains Taxes on Transferred Real Estate.

For many elderly persons in the middle class, a key tax goal is to keep the home includable in the person’s gross estate for federal estate tax purposes. Doing so results in a step-up in the basis of the home under Internal Revenue Code Section 1014, and the persons inheriting the home essentially receive, free of any capital gains tax, the appreciation in value from the time of the initial purchase of the home.

For example, suppose a person who paid $10,000.00 for a home dies when it is worth $200,000.00. The appreciation of $190,000.00 escapes capital gains tax if the home is includable in the person’s gross estate for federal estate tax purposes.

For a person who wishes to give away the home, the most common method of doing so may be to give away the remainder interest while reserving a life estate. Internal Revenue Code Section 2036 states that “the gross estate shall include the value of all property… of which the decedent has at any time made a transfer… under which he has retained for his life… the possession or enjoyment, or the right to the income from, the property.” Thus, if the person deeds the home to others, yet explicitly reserves a life estate, the full fair market value of the home is includable in the client’s gross estate for federal estate tax purposes and the transferees thereby receive the desired step-up in basis upon the client’s death.

Unfortunately, some persons deed away their homes without reserving a life estate. Arguably, the federal estate tax inclusion ends up being lost by such a maneuver, but the literal language of Section 2036 quoted above can salvage the step-up in basis.  Note that the word “reserved” is not used in Section 2036; rather the word “retained” is used. Retained is a broader term. The Internal Revenue Service has successfully argued in the past that a right can be retained without having been reserved, and that the continued occupancy of the home after the transfer of title, without paying fair market rent, is evidence of an implicit agreement, understanding or assumption of the parties of the transaction. (See Estate of Linderme, 52 T.C. 305 (1969).)

For example, if a person deeds the same home described above but reserves a life estate, upon the person’s death the home is includable on the Federal Estate Tax Return and the transferees receive a stepped-up basis of $200,000.00. If the person making the transfer had not reserved the life estate, but continued to live there rent-free or for less than fair market rent, the home should be included on the Federal Estate Tax Return as a “retained life estate” if a step-up in basis is desired.

One final note: under Internal Revenue Code Section 2035, a release of a life estate is ineffective for federal estate tax purposes for three (3) years. This means that a life estate that is released within three (3) years of death is included in the gross estate and results in the desired step-up in basis. Thus, if the life tenant under a retained life estate moves out of the home and dies within 3 years of moving out, estate tax inclusion under Section 2035 can result. Further, if a person insists on making an outright transfer (perhaps due to Medicaid estate recovery concerns), it may be better to structure the transaction as a deed with a reserved life estate, then have the person release the life estate at a later time.