11. Retained Life Estates and Remainder Interests in Homes and Farmlands, Part 1 of 2

11. Retained Life Estates and Remainder Interests in Homes and Farmlands, Part 1 of 2

Article posted in General on 27 April 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 4 May 2016
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VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

11. RETAINED LIFE ESTATES AND REMAINDER INTERESTS IN HOMES AND FARMLANDS, PART 1 of 2

Links to previous sections of book are found at the end of each section.

In this chapter, we will examine the somewhat-less-well-known charitable planning strategy of donating a remainder interest in a personal residence or farmland while retaining the life estate.  This topic is useful for two reasons.  First, this strategy can be valuable for donors with an interest in leaving a bequest gift who would also like to receive an immediate income tax deduction for their commitment.  The remainder interest with retained life estate gift instrument itself is relatively simple, and because few fundraisers or advisors are familiar with this option, it may prove to be a useful niche strategy that can lead to attractive opportunities.

Second, this is the simplest type of planned gift that generates an immediate tax deduction for a transfer that will usually benefit the charity only years later.  Typically, the charity becomes the owner of the property only after one or more lifetimes (or sometimes after a fixed number of years).  This same concept—a transaction that benefits a charity primarily in the distant future, but still generates an immediate income tax deduction—appears in a number of more complex contexts.  This same idea appears again in charitable structures such as Charitable Remainder Trusts and grantor Charitable Lead Trusts.  But, in those cases the idea is combined with other financial benefits coming back to the donor from the trust.  Before advancing to these more complex structures, it may benefit the reader to understand this relatively straightforward gift.  In this way the remainder interest gift with a retained life estate is not only an independently useful transaction, but serves an important conceptual building block for even more sophisticated planning.

As was addressed in a previous chapter, a partial interest gift with retained interests occurs when a donor donates some types of rights to property, but keeps other types of rights in the gifted property.  Remainder interest gifts with retained life estates are exactly this type of transaction.  The donor gives a remainder interest (the right to own after death or after a period of years) in a home or farmland to charity, but keeps the right to use the property in the meantime (during life or for a period of years).

The general rule is that if a donor retains an interest in gifted property (giving the charity only a partial interest), the donor may not take a deduction for that type of transaction.
Gifts of remainder interests in a personal residence or farmland are a special exception to the general rule against deducting partial interest gifts where the donor retains other ownership interests in the gifted property.  The other special exceptions to this general rule are Charitable Remainder Trusts, Charitable Lead Trusts, Pooled Income Funds, and qualified conservation easements.
In many ways, a remainder interest gift with a retained life estate is similar to a will.  A remainder interest gives the right to someone else to become the owner of property after the death of the current owner (or another person) or after a certain number of years.  Typically, the donor, who owns the property, gives a charity the right to own the property after the donor’s death (or after the last to die of the donor and the donor’s spouse).  But, it is also possible to set up a remainder interest in a variety of different ways.  Any person or persons can be used as the “measuring life” after which the property would go to the charity as the remainder interest holder.  For example, a donor could gift a remainder interest to a charity that takes effect only after the death of the donor, the donor’s spouse, and all currently living children and grandchildren of the donor.  Although the charitable deduction for such a transfer might be relatively small—given the likely number of years the charity would have to wait to become the owner of the property—there would still be some charitable deduction.  In another twist, a donor could give a charity the right to own the property after the death of, for example, the donor’s sister and then donate the right to use the property for her life to the sister.  Many such constructions are allowed, but they are also quite rare compared with the standard approach of the donor retaining a lifetime right to use the property (i.e., retaining a life estate) and giving the remainder interest to the charity.

Although it transfers full ownership of property at death, the remainder interest with retained life estate differs from a will in important respects.  Unlike a will, the decision to transfer a remainder interest in real estate is not revocable.  Once the remainder interest is given, it is immediately owned by the recipient.  This can be a tricky concept to understand.  Even though a remainder interest might not result in the transfer of full ownership until after the death of the donor, that right to receive the property at death is immediately owned by holder of the remainder interest.  Because this right is immediately owned by the remainder interest holder, it can even be sold.

For example, suppose a donor gives a remainder interest in his home to his favorite charity while retaining the life estate.  This gives the charity ownership of the right to receive the home at the death of the donor.  The charity could wait until the donor dies and then the charity would become the full owner of the home.  However, the charity could instead immediately sell this right to an investor, in which case the investor would receive the home at the death of the donor.  The home, at the death of the original owner, will be owned by whoever owns the remainder interest at that time.  These later transfers have no effect on the charitable deduction.  (In the same way, the charitable deduction for a donation of a share of stock is not affected by whether or not the charity later sells the stock to someone else).  It is this irrevocable and transferable nature of the remainder gift that makes it immediately deductible.  Because the charity has received a valuable right today (one that can even be sold today), the donor can take a charitable deduction today even though she retains the right to use the property for the rest of her life.  In contrast, no income tax deduction results from naming a charity in a will, because the charity has no rights prior to the donor’s death.  The charity can be removed from a will at any time, but giving a remainder interest deed is permanent.

Although the donor cannot prevent the future transfer of these rights from the charity to another buyer, it would be common for the charity to communicate with the donor in advance regarding its plans.  In some cases, the donor may encourage the charity to sell the rights in advance, so that the donor may see the impact of his gift while he is still alive.  For some donors, this is an attractive concept that would be impossible if using a will instead of a remainder interest deed.

This remainder interest gift must be transferred by means of a remainder interest deed.  Even an otherwise identical arrangement created by a trust or a contract will not generate an income tax deduction.  Only a deed will work.  This makes the transaction documentation extraordinarily simple.  Using a standard deed form with the transferee listed as “life estate to John A.  Donor, remainder interest to XYZ charity” will usually be effective.  (The simplicity of this transaction may, ironically, contribute to its underutilization as some attorneys may favor more complex arrangements that generate more billable hours.)
Taking a charitable deduction for the transfer of a remainder interest to charity is limited to specific types of property.  Only two types of property are eligible: farmland and a donor’s personal residence(s).  Any land and improvements used to raise crops or livestock qualifies as farmland.  The land will qualify as farmland even if the donor is not farming the land himself, so long as someone is using it to raise crops or livestock.  Land being used to raise crops or livestock is farmland, even if its valuation is based upon its usefulness as commercial development property.
A donor need not transfer a remainder interest in his entire farm, but can deduct a remainder interest gift in any part of a farm.  (Using the term “farmland” rather than “farm” avoids the impression that the donor’s entire farm must be given to charity at death in order to take this deduction.) For example, the donor who owns a 1,000 acre farm can take an immediate income tax deduction for giving a remainder interest in 10 acres of that farm.
The donor can identify specific acreage within a farm to be gifted by a remainder interest deed while keeping the life estate (i.e., right to use during life).  But, could the donor deduct a remainder interest gift of an undivided share in farmland?  In other words, could a donor deduct the gift of a remainder interest in an undivided 10% interest in 100-acres of farmland, rather than a remainder interest in 10 specific acres?
The answer is, “Yes.”  Thus, a donor could make a remainder interest gift of 5% of his farmland.  The donor could even choose to do this every year for 20 years until all of the remainder interest in the farmland was transferred.  Such a spreading out of deductible gifts might be attractive to a donor, depending upon the donor’s tax circumstances and the ongoing appreciation of the property.  Appreciation is important because the value of each gift increases as the value of the underlying farmland also increases.  Further, each gift may generate a greater deduction because the donor is one year older at each transfer, making the remainder interest more valuable due to the reduced life expectancy of the donor.  (This is, of course, assuming the typical arrangement where the donor’s life is the measuring life for the life estate after which the property is transferred.) However, the deduction for such undivided interest gifts may be slightly reduced based upon the cost that a charity could incur to force a sale or division of the property (called “partitioning”).
Can a donor deduct the transfer of a remainder interest in mineral rights while retaining a lifetime right to use them?  If the donor is transferring a remainder interest in only the mineral rights, this will not qualify for a charitable deduction.  Mineral rights, by themselves, do not constitute farmland.  Farmland is land used to raise crops or livestock.  Mineral rights, by themselves, cannot be used to raise crops or livestock.  However, if the donor is transferring a remainder interest in farmland that includes both the farmland surface rights and mineral rights, this constitutes a deductible gift.  Thus, the value of the gift will be based upon the total value of the land including both surface rights and mineral rights.  But, this is only available if the mineral rights are transferred as part of the transfer of the farmland.  It is also acceptable to deduct the transfer of a remainder interest in farmland where the donor does not own any mineral rights.

As mentioned above, transferring the remainder interest in farmland generates a charitable deduction.  But, how much is this deduction?  Certainly, the deduction will be less than if the donor immediately gave the land to the charity, but, how much less?  The deduction will be the present value of the right to receive the land in the future.  This present value depends upon the current value of the land, the interest rate, and how long the charity would likely wait to receive the land (i.e., the life expectancy of the donor if the donor is the measuring life for the retained life estate).

As a practical matter, the calculation can be completed by identifying the interest rate (known as the §7520 rate) found at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Section-7520-Interest-Rates and then using the interest rate to identify the correct remainder percentage for one or two lives or a specific term from the tables at www.irs.gov/Retirement-Plans/Actuarial-Tables  Let’s walk step-by-step through the process for completing such a calculation.

Suppose we wish to calculate the charitable deduction for a remainder interest gift in $100,000 of farmland given by a 59-year-old donor on January 31 of 2015 where the charity receives the right to own the farmland upon the death of the donor.  For this calculation, the age of the donor is the age at their nearest birthday on the date of the gift.  First, we must identify the appropriate §7520 interest rate.  Following the link www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Section-7520-Interest-Rates on January 31 of 2015 displays the table containing the §7520 interest rate.  The donor can choose the interest rate from the current month or the previous two months.  In this case, the interest rate in the current month was 2.2% and the interest rate in the prior month was 2.0%.  Which interest rate should the donor choose?

For gifts of remainder interests in homes and farmland the charitable deduction increases as the interest rate decreases.  Consequently, the donor should always choose the lowest available interest rate.  The gift to charity is calculated as the present value of receiving the farmland (at its current value) when the charity must first wait for the current life expectancy of the donor to expire.  If interest rates are very low (e.g., 1%), then the cost of waiting is also very low.  When the cost of waiting is low, the value of a gift requiring waiting will be relatively high.  When the cost of waiting is high (e.g., a 10% interest rate), the value of a gift requiring waiting will be relatively low.

It may help to think about the present value of a remainder interest gift in these terms: How much money would a person have to put in the bank today such that it would be worth $100,000 at the end of the current life expectancy of the measuring life?  If the bank paid 1% interest on the account, then a larger initial deposit would be required than if the bank paid 10% interest on the account.  Similarly, the present value of a remainder interest gift with a retained life estate is higher if the prevailing interest rate (a.k.a. the §7520 rate) is lower.

The impact of different interest rates on the charitable deduction for a remainder interest deed can be seen dramatically in this example.  If the §7520 interest rate used is 11.6%, then the deduction for a gift of a remainder interest deed with retained life estate in $1 million of farmland by a donor aged 59 is $156,840.  If the §7520 interest rate is 1.0% the deduction is $804,790.  Since both of these interest rates were, at different times, the actual §7520 interest rate, this demonstrates real differences in the deduction of otherwise identical transactions.  This is also why gifts of remainder interests in homes and farmland are so attractive during a low interest rate environment.  This remainder interest giving technique is useful to keep in mind during such times because other more common techniques (such as Charitable Remainder Annuity Trusts) are often less attractive during a low interest rate environment.

Understanding the relationship between interest rates and the charitable deduction for gifts of remainder interests results in selecting the lowest available interest rate from the §7520 table in the current or previous two months.  In this example, the lowest interest rate is 2.0%.  Consequently, we will use 2.0% as the interest rate for all subsequent calculations in this example.
To find the percentage of the value of the land that will be deductible with a remainder interest gift, we must download the relevant table.  (Links to these tables may be found at www.irs.gov/Retirement-Plans/Actuarial-Tables) The tables provided allow calculations for a remainder interest when transferring at the death of one person, at the last to die of two people, or after a specific number of years (term certain).  In the current example, we are calculating the deduction for a gift of a remainder interest in $100,000 of farmland given by a 59-year-old donor on January 31 of 2015 where the donor is the “measuring life” for the remainder interest.  Consequently, we will click on Table S, which contains the single life factors.  If the remainder interest would transfer to the charity at the death of the last to die of the donor and the donor’s spouse, for example, then we would need to click on one of the table R(2) links (in this case, the first one, because it contains the remainder factors for a 2.0% interest rate).

Clicking on the Table S link downloads an Excel file.  The first task is to scroll down through the Excel file until reaching the portion of the table labeled as “Interest at 2.0 Percent,” because this is the §7520 interest rate being used in this example.  In this section, the row associated with the age of the donor/measuring life shows a remainder interest factor of 0.65553.  In simple terms, this factor means that this remainder interest gift will generate a charitable tax deduction of 65.553% of the value of farmland. 

As you can see when scrolling through the table, the charitable deduction will be larger when the measuring life for the remainder interest is older.  This makes sense because as age increases, life expectancy decreases, meaning that the charity will, on average, receive the property earlier.

Once the remainder interest factor has been correctly identified, the calculation for the deduction is simple.  In this case, the donor can deduct 65.553% of the value of any land in which he makes a remainder interest gift subject to his lifetime right to use the property.  Thus, the charitable income tax deduction for such a remainder interest gift with a retained life estate in $100,000 of farmland is $65,553.
For a donor who has intent to leave a bequest gift to charity, a remainder interest gift may be particularly attractive.  In both cases—whether through a will or through a remainder deed—the charity receives a gift at death.  However, with a remainder interest deed, the donor receives an immediate income tax deduction that can often be very large.  This does come at a cost.  The primary cost is that the remainder interest gift, unlike a will, is irrevocable.  The donor cannot later change his mind and decide to take back the remainder interest gift.  Also, to be deductible, a remainder interest gift must be a gift of farmland or a home.  Because of typical mortgage prohibitions against transfers, such a gift normally requires debt-free farmland or a debt-free house.  Some donors may also be attracted by the reality that a charity can sell the remainder interest, and thereby generate immediate cash for current projects.  The substantial tax deduction may also benefit the donor by increasing spendable assets (which now do not have to be spent on tax payments).  This may be particularly attractive for a donor who does not wish to sell the home or farmland, but wishes to get an immediate monetary benefit from the property in order to supplement current income.

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