Life Estate Agreements

Life Estate Agreements

Technical Report posted in Life Estate Agreement on 5 May 2003| 1 comments
audience: National Publication | last updated: 10 June 2014
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Abstract

A gift of a remainder interest in a personal residence or farm is described generally as a transaction in which an individual irrevocably transfers title to a personal residence or farm to a charitable organization with a retained right to the use of the property for a term that is specified in the gift agreement. At the conclusion of the measuring term, all rights in the property are transferred to the charitable remainderman. This memorandum reviews the income, gift, and estate tax consequences surrounding life estate agreements and the practical issues surrounding their creative use and implementation.

A gift of a remainder interest in a personal residence or farm is described generally as a transaction in which an individual irrevocably transfers title to a personal residence or farm to a charitable organization with a retained right to the use of the property for a term that is specified in the gift agreement. At the conclusion of the measuring term, all rights in the property are transferred to the charitable remainderman.

Gifts of a remainder interest in a personal residence or farm can be measured by the life of one or more individuals, by a fixed term of years, or by a combination of the two. They are, however, most frequently established to operate for the life or lives of the residents of the contributed property. Accordingly, they are frequently referred to as "life estate agreements."

Life estate agreements are ideal planning vehicles for those individuals who desire to make a testamentary gift of real property to charity, yet enjoy a current and potentially substantial charitable income tax deduction. The balance of this memorandum reviews the income, gift, and estate tax consequences surrounding life estate agreements and the practical issues surrounding their creative use and implementation.

Definition of Personal Residence or Farm

Personal Residence

The regulations define a "personal residence" as any property used by the taxpayer as a personal residence even though it is not used as the principal residence. For example, the taxpayer's vacation home may be a personal residence. Personal residences also include stock owned by a taxpayer as a tenant-stockholder in a cooperative housing corporation (as defined in IRC §216(b)(1) and (2)) if the dwelling the taxpayer is entitled to occupy as such stockholder is used as his or her personal residence.1 In Ltr. Rul. 8529014,the Service also ruled privately that any capital improvements (e.g., the installation of a permanent new heating and air-conditioning system) constitute an additional contribution for which a charitable contribution deduction is permitted.

IRC §163, which deals with Qualified Personal Residence Trusts, defines a "residence" to include a house, condominium, mobile home, boat, or house trailer, that contains sleeping space, toilet, and cooking facilities.2 The authors are not aware of any rulings, however, regarding whether these types of residences qualify for purposes of IRC §170. Because the computation of the present value of the remainder interest considers depreciable property, it is not inconceivable that the Service would permit these forms.

Residence Does Not Include Furnishings

A personal residence does not include household furnishings (such as furniture, paintings, linen, silverware etc.) that are not fixtures and a gift of a remainder interest in such tangibles will not qualify for the estate tax charitable deduction. 3 If such items are to be contributed, they should be bequeathed separately.

Rental Property

In Ltr. Rul. 8711038, the Service ruled privately that a "personal residence" may also include a rental property. The facts of this ruling state that the taxpayer rented a portion of the property to an unrelated third property. In its analysis, the Service cited Rev. Rul. 78-303 which held that a farmer, a portion of whose farm was leased to an unrelated third party, could deduct as a charitable contribution a gift not in trust to an exempt educational organization of an irrevocable remainder interest in a portion of the leased land in which the farmer retained a life estate." The Service did not state whether or not the partial retained use by the donor was material to its ruling; however, because the Service has ruled that a farm that is leased in its entirety qualifies, the same logic should apply to a personal residence. Further, because there are no rules that prohibit the life tenant from renting a personal residence during the term of their retained estate, it would also seem logical that the transfer of personal residence property that is rented in its entirety at the time of the gift should qualify. The authors are not aware of any rulings to support this hypothesis, however. See also Ltr. Rul. 8225158

Farm Defined

A "farm" is defined as "any land used by the taxpayer or his tenant for the production of crops, fruits, or other agricultural products or for the sustenance of livestock." The term "livestock" includes "cattle, hogs, horses, mules, donkeys, sheep, goats, captive fur-bearing animals, chickens, turkeys, pigeons, and other poultry." It seems that with such a lengthy list that Treasury might be splitting "hares." A farm also includes the improvements thereon.4

Federal Income Tax Consequences

Generally, no deduction is allowed for federal income tax purposes for any contribution of a partial interest in property to charity, unless the contribution takes the form of a qualified charitable remainder annuity trust, charitable remainder unitrust, or pooled income fund. There are, however, several exceptions to this rule for transfers of partial interests in property not in trust. These exceptions include:

  • a contribution of a remainder interest in a personal residence or farm
  • a contribution of an undivided portion of the taxpayer's entire interest in property, and
  • a qualified conservation contribution.5

Present Value of Remainder Interest

With respect to gifts of a remainder interest in a personal residence or farm, the donor is entitled to a charitable contribution income tax deduction in an amount equal to the net present value of the charitable remainder interest. The computation is performed under the guidelines described in Reg. §1.170A-12 and is based on the:

  • fair market value of the property (including improvements) on the date of transfer;
  • fair market value of depreciable improvements attached to or depletable resources associated with the property on the date of transfer;
  • estimated useful life of the depreciable improvements;
  • salvage value of the depreciable improvements at the conclusion of their useful life;
  • measuring term of the agreement (if measured by the life of one or more individuals, the date of birth of the individuals); and
  • Applicable Federal Midterm Rate (in effect for the month of transfer or during either of the two preceding months)

Each of the components of the computation of the present value of remainder interest are described in greater detail:

Fair market value

Because the amount claimed as a charitable contribution deduction most often exceeds $5,000.00, the fair market value of property must be established by a qualified independent appraisal. For purposes of the computation, the fair market value is reduced by any indebtedness secured by the property.

Depreciable and Depletable Property

If any part of the real property is subject to exhaustion, wear and tear, or obsolescence, a special factor is used in valuing the remainder interest in that part. Further, if any part of the property is subject to depletion of its natural resources, such depletion is taken into account in establishing the present value of the remainder interest. Depreciation and depletion are computed using the straight-line method over the asset's useful life.6

Estimated Useful Life

The term "estimated useful life" means the estimated period (beginning on the date of contribution) over which the property may reasonably be expected to be useful for its expected use. The estimated useful life is not limited to the measuring term of the life estate or term of years preceding the remainder interest; rather, consideration is to be given to the provisions of the governing instrument or applicable local law, if any, relating to the use, preservation, and maintenance of the property. For this purpose, the estimates of engineers or other persons skilled in estimating the useful life of similar property may be used. As an alternative, the taxpayer can use a depreciable schedule for similar property class pursuant to Reg. §1.167(a)-11(b)(4) in effect on the date of transfer.7

Salvage Value

The salvage value is the estimated value of the depreciable or depletable property that remains at the end of its useful life.

Measuring Terms

Life estate agreements are most frequently measured by the lifetime of one or more individuals; however, the agreement can also be measured by a term of years or by the longer of the life or lives of individuals and a term of years. If the agreement is measured by one or more lives, the individuals must be in being at the time the agreement is created. If the agreement is measured by a fixed term of years, there is no minimum or maximum term for federal tax purposes; however, state law may impose limitations.

It should be noted that if an individual who is a measuring life is terminally ill at the time of the transaction, the mortality component prescribed under IRC §7520 need not be used to determine the present value of the remainder interest. For this purpose, an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50 percent probability that the individual will die within one year. However, if the individual survives for eighteen months or longer after the date of the transaction, that individual shall be presumed to have not been terminally ill at the time of the transaction unless the contrary is established by clear and convincing evidence.8

Applicable Federal Midterm Rate

The Applicable Federal Midterm Rate as described in IRC §7520 in effect for the month of the gift is used as the interest component for present value computation purposes. At the election of the donor, the interest rate in effect for either of the two months preceding the gift can be substituted. An archive of these rates is available here.

Sample Present Value Computations

The following examples illustrate present value computations based on single-life, two-life (joint and survivor), term of years, and two life and term concurrent.

Example 1. Single Life Present Value Computation

Mrs. Jones, age 70, transfers a remainder interest in her personal residence to donee on January 1, 1998. On the date of transfer the property has a fair market value of $250,000. The agreement will be measured by Mrs. Jones' life. The depreciable portion of the property has been estimated at $125,000 and has an estimated useful life of 45 years. The salvage value of the depreciable portion has been estimated at $12,500. The Applicable Federal Midterm Rate for January, 1998 is 7.4%. The computation of the present value of remainder interest based on one life as described in Reg. §20.2031-7 follows:

Remainder Interest in a Personal Residence or Farm
One Life
Mr. and Mrs. Jones

Input Assumptions:
Date of transfer 01/01/1998
Current fair market value of entire property 250,000.00
Current value of depreciable property (improvements) 125,000.00
Estimated useful life of depreciable property in years 45
Expected salvage value of depreciable property 12,500.00
This calculation uses a hypothetical future discount rate of 7.40%
The mortality table is based on the census taken in 1980
Mrs.'s nearest age on the date of the gift is 70
Calculation of Income Tax Deduction:
1. Age of life tenant 70
2. Estimated useful life of depreciable property in years 45
3. Line 1 plus Line 2 115
4. The lesser of Line 3 or 110 years (the terminal age) 110
5. R-Factor opposite age on Line 1 from Table C 1,956.848
6. R-Factor opposite age on Line 4 0.00
7. Line 5 minus Line 6 1,956.848
8. D-Factor opposite age on Line 1 from Table C 461.0948
9. Line 2 times Line 8 20,749.266
10. Line 7 divided by Line 9 (depreciation adjustment factor) 0.09431
11. Remainder factor in Table S corresponding to age of tenant 0.44516
12. Line 11 minus Line 10 0.35085
13. Current value of depreciable life estate property 125,000.00
14. Salvage value of depreciable life estate property 12,500.00
15. Depreciation (Line 13 - Line 14) 112,500.00
16. Line 15 times Line 12 39,470.71
17. Current fair market value of life estate property 250,000.00
18. Ending value of life estate property (Line 17 - Line 15) 137,500.00
19. Line 18 times Line 11 61,209.50
20. Present value of remainder interest (Line 19 + Line 16) (the current income tax deduction) 100,680.21

Example 2. Two Life Present Value Computation

Mr. and Mrs. Jones, ages 75 and 70, transfer a remainder interest in their personal residence to donee on January 1, 1998. The agreement will be measured by Mr. and Mrs. Jones' lives. On the date of transfer the property has a fair market value of $250,000. The depreciable portion of the property has been estimated at $125,000 and has an estimated useful life of 45 years. The salvage value of the depreciable portion has been estimated at $12,500. The Applicable Federal Midterm Rate for January, 1998 is 7.4%. The computation of the present value of remainder interest based on two lives as described in Reg. §20.2031-7 follows:

Remainder Interest in a Personal
Residence or Farm
Term Certain Plus One Life
Mr. and Mrs. Jones

Input Assumptions:
Date of transfer 01/01/1998
Current fair market value of entire property 250,000.00
Current value of depreciable property (improvements) 125,000.00
Estimated useful life of depreciable property in years 45
Expected salvage value of depreciable property 12,500.00
This calculation uses a hypothetical future discount rate of 7.40%
The mortality table is based on the census taken in 1980
Mrs.'s nearest age on the date of the gift is 70
The guaranteed period to use the property is 20 years  
Calculation of Income Tax Deduction:
1. Current fair market value of life estate property 250,000.00
2. Current value of depreciable portion of life estate property 125,000.00
3. Salvage value of depreciable life estate property 12,500.00
4. Portion of property considered to be depreciable (Line 2 - Line 3) 112,500.00
5. Net value of property not subject to depreciation (Line 1 - Line 4) 137,500.00
6. Remainder interest factor based on tenant ages 0.44516
7. Remainder interest depreciation factor for real property:  
(a) Depreciation factor during term certain 0.10561
(b) Depreciation factor after term certain 0.01773
(c) Total depreciation factor (7(a) + 7(b)) 0.12334
8. Value of remainder interest in real property:  
(a) Value not subject to depreciation (Line 5 * Line 6) 61,209.50
(b) Value subject to depreciation (Line 4 * Line 7(c)) 13,875.75
(c) Total value of remainder interest (Line 8(a) + Line 8(b)) (the current income tax deduction) 75,085.25

Term of Years Present Value Computation

Mr. Jones transfers a remainder interest in his personal residence to donee on January 1, 1998. The agreement will be measured by a term of twenty years. On the date of transfer the property has a fair market value of $250,000. The depreciable portion of the property has been estimated at $125,000 and has an estimated useful life of 45 years. The salvage value of the depreciable portion has been estimated at $12,500. The Applicable Federal Midterm Rate for January, 1998 is 7.4%. The computation of the present value of remainder interest based on a term of years as described in Reg. §25.2512-5 follows:

Remainder Interest in a Personal Residence or Farm
Two Lives
Mr. and Mrs. Jones

Input Assumptions:
Date of transfer 01/01/1998
Current fair market value of entire property 250,000.00
Current value of depreciable property (improvements) 125,000.00
Estimated useful life of depreciable property in years 45
Expected salvage value of depreciable property 12,500.00
This calculation uses a hypothetical future discount rate of 7.40%
The mortality table is based on the census taken in 1980
Mr.'s nearest age on the date of the gift is 75
Mrs.'s nearest age on the date of the gift is 70
Calculation of Income Tax Deduction:
1. Current fair market value of life estate property 250,000.00
2. Current value of depreciable portion of life estate property 125,000.00
3. Salvage value of depreciable life estate property 12,500.00
4. Portion of property considered to be depreciable (Line 2 - Line 3) 112,500.00
5. Net value of property not subject to depreciation (Line 1 - Line 4) 137,500.00
6. Remainder interest factor based on tenant ages 0.35212
7. Remainder interest factor for real property which depreciates 0.24883
8. Value of remainder interest in real property:  
(a) Value not subject to depreciation (Line 5 * Line 6) 48,416.50
(b) Value subject to depreciation (Line 4 * Line 7) 27,993.38
(c) Total value of remainder interest (Line 8(a) + Line 8(b)) (the current income tax deduction) 76,409.88

Life and Concurrent Term of Years Present Value Computation

Mr. and Mrs. Jones transfer a remainder interest in his personal residence to donee on January 1, 1998. The agreement will be measured by the longer of both of their lives or a term of twenty years.

On the date of transfer the property has a fair market value of $250,000. The depreciable portion of the property has been estimated at $125,000 and has an estimated useful life of 45 years. The salvage value of the depreciable portion has been estimated at $12,500. The Applicable Federal Midterm Rate for January, 1998 is 7.4%. The computation of the present value of remainder interest based on a term of years as described in Regs. §§20.2031-7 and 25.2512-5 follows:

Remainder Interest in a Personal Residence or Farm
Term Certain Plus Two Lives
Mr. and Mrs. Jones

Input Assumptions:
Date of transfer 01/01/1998
Current fair market value of entire property 250,000.00
Current value of depreciable property (improvements) 125,000.00
Estimated useful life of depreciable property in years 45
Expected salvage value of depreciable property 12,500.00
This calculation uses a hypothetical future discount rate of 7.40%
The mortality table is based on the census taken in 1980
Mr.'s nearest age on the date of the gift is 75
Mrs.'s nearest age on the date of the gift is 70
The guaranteed period to use the property is  
Calculation of Income Tax Deduction:
1. Current fair market value of life estate property 250,000.00
2. Current value of depreciable portion of life estate property 125,000.00
3. Salvage value of depreciable life estate property 12,500.00
4. Portion of property considered to be depreciable (Line 2 - Line 3) 112,500.00
5. Net value of property not subject to depreciation (Line 1 - Line 4) 137,500.00
6. Remainder interest factor based on tenant ages 0.35212
7. Remainder interest depreciation factor for real property:  
(a) Depreciation factor during term certain 0.09623
(b) Depreciation factor after term certain 0.02421
(c) Total depreciation factor (7(a) + 7(b)) 0.12044
8. Value of remainder interest in real property:  
(a) Value not subject to depreciation (Line 5 * Line 6) 48,416.50
(b) Value subject to depreciation (Line 4 * Line 7(c)) 13,549.50
(c) Total value of remainder interest (Line 8(a) + Line 8(b)) (the current income tax deduction) 61,966.00

Claiming the Charitable Contribution Income Tax Deduction

The majority of gifts of a remainder interest in personal residence or farm are made with property that has been held long-term by the donor to a public charitable organization as described in IRC §170(b)(1)(A). Accordingly, the present value of remainder interest is deductible against 30% of the donor's contribution base (adjusted gross income without regard to net operating loss carryback into the contribution year) with a five year carryover of any excess deduction. If the property would be subject to any depreciation recapture as ordinary income if sold on the date of contribution, those amounts are subtracted from the fair market value of the property for purposes of calculating the present value of remainder interest. The donor must include a copy of the computation with his or her income tax return. Furthermore, in the event the claimed deduction exceeds $5,000, the fair market value of the property must be evidenced by a qualified appraisal.

Transferring Debt Encumbered Property

A gift of a remainder interest in a personal residence or farm does not cause recognition of gain or loss on transfer to the donor provided the property is not debt encumbered. If the property is subject to indebtedness, however, the transaction is subject to the bargain sale rules.

When debt encumbered property is transferred to charity by outright gift, the entire amount of the indebtedness is considered an amount realized by the donor for purposes of application of the bargain sale rules of IRC §1011(b). In essence, the transaction is treated as though the charity has handed the donor cash in the amount of the indebtedness because the donor has been relieved of the payment obligation. If the property is appreciated, the donor realizes gain in the same amount that would have been realized had donor sold a fractional interest in the property equal to the indebtedness. In other words, the entire gain in the property is prorated in relation to the fraction the indebtedness related to the entire fair market value of the property. It is logical to think that when a remainder interest in debt encumbered property is transferred to charity, only that portion of the debt applicable to the charitable gift portion (i.e., the remainder interest) should be used for purposes of determining realized gain. Logic, however, does not seem to apply to such transactions.

Service Rules Entire Gain Attributable to Indebtedness Realized by Donor

The only guidance offered by the Service on this issue is found in Ltr. Rul. 9329017. In the request for ruling, the taxpayer proposed to transfer the remainder interest in a farm to charity with a retained life estate. The property had a fair market value of $110,000 and was subject to a $80,000 mortgage. The Service ruled that the present value of the remainder interest would be calculated based on the taxpayer's equity -- $30,000. In the years that followed the contribution, the taxpayer would also be entitled to claim additional charitable contribution deductions for the present value of the remainder interest attributable to the repayment of principal. The Service then ruled that the taxpayer would realize the entire amount of the indebtedness for purposes of determining realized gain under the bargain sale rules. This result was surprising because unlike an outright gift, in which the taxpayer is relieved of the payment obligation, the taxpayer in this case was to remain responsible for future mortgage payments under the gift agreement! If the taxpayer had a low cost basis, the realized gain could easily exceed the entire charitable contribution deduction. In other words, the donor could incur a net income tax liability and still have to make the mortgage payments.

The authors believe the IRS should revise its position to hold that donors should only realize gain attributable to the portion of the indebtedness allocable to the present value of the remainder interest.

Application of $250,000 Capital Gain Exclusion to Sales of Remainder Interests or Transfers of Debt-Encumbered Property

The Taxpayer Relief Act of 1997 amended IRC §121 (relating to one-time exclusion of gain from sale of principal residence by individual who has attained age 55) and repealed IRC §1034 (relating to the rollover of gain attributable to a personal residence).

Under the new law, gain from the sale or exchange of a personal residence occurring after May 6, 1997 (to the extent it does not exceed $250,000 for an individual or $500,000 for a married couple meeting certain requirements) is not includible in gross income if, during the five-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating two years or more.9 This rule applies to the sale of one residence every two years.

With respect to sales of remainder interests, IRC §121 also specifically provides that "at the election of the taxpayer, this section shall not fail to apply to the sale or exchange of an interest in a principal residence by reason of such interest being a remainder interest in such residence, but this section shall not apply to any other interest in such residence which is sold or exchanged separately."10

Although the Service has not specifically addressed this issue, it did issue a favorable ruling that permitted a donor to exclude gain (to the extent of the limitations of IRC §121) arising from the sale of a personal residence to charity in exchange for a charitable gift.11 The authors believe the exclusion should apply to both the gain resulting from the sale of a remainder interest to charity and gain realized in connection with the transfer of a remainder interest in debt-encumbered property.

Gift and Estate Tax Considerations

Gifts of a remainder interest in a personal residence or farm to charity qualify for unlimited gift and estate tax deductions for the present value of the remainder interest. However, a gift or estate tax can be generated on the value of the retained income interest if it is transferred to someone other than the donor, the donor's spouse, or charity.

Donor as Sole Tenant

If a donor transfers a remainder interest in her personal residence naming herself as the sole life tenant, the transfer qualifies for the charitable gift tax deduction in an amount equal to the present value of the remainder interest in the year the transfer is made.12 Because the donor retains the interest, there are no further gift tax consequences. Upon her death, the full value of the property is includible in her estate.13 However, the full value of the property will also be deducted from her taxable estate via the estate tax charitable deduction.14

Non-Donor as Tenant

When a donor creates a life estate agreement naming another person as a tenant, the donor has made a potentially taxable gift of a retained interest to the tenant.

Computation of Taxable Gift when Non-Donor is Sole Tenant

When one or more non-donors are the sole tenants of the agreement, the amount of the taxable gift is obtained by subtracting the present value of the remainder interest from the fair market value of the property. It is important to note that the computation of the present value of remainder interest is NOT the same as used for income tax deduction purposes; computations for federal gift tax purposes do not consider the depreciable portion of the property.15 Therefore, the entire fair market value of the property is considered non-depreciable property for purposes of this computation. This distinction results in higher gift tax deductions than if depreciation was considered.

Example: A father, age 85, transfers a $250,000 farm to charity with a retained life estate to his son, age 60. The AFMR is 7.2%.16 Based on these assumptions, the present value of remainder interest is $78,292. The son's life interest and, therefore, the taxable gift are $171,708. Assuming there are no depreciable structures on the property, the father would also receive a current charitable contribution income tax deduction in the amount of $78,292.

Computation of Taxable Gift with Donor and Non-Donor Tenants

If the donor and non-donor are cotenants, the amount of the taxable gift depends on whether the non-donor income has a concurrent or successive tenancy interest.

The following computations have not been approved or disapproved by the IRS; they are based on informal conversations with staff members of E.A.G., U.S. Department of the Treasury. Advisors are urged to confirm the accuracy of these computations with Treasury.

Non-Donor as Primary Life Tenant and Donor as Successor Life Tenant

When a non-donor is the primary tenant for life followed by the donor, the amount of the taxable gift is equal to the present value of the retained life interest based solely on the non-donor's life. In other words, the presence of the donor as a successor tenant has no impact on the non-donor's enjoyment of the estate. The computation of the taxable gift is, therefore, no different than if the non-donor is the sole tenant.

Donor as Primary Life Income Tenant and Non-Donor as Successor Life Tenant

When the donor is the primary tenant followed by the non-donor as successor tenant, the taxable gift is equal to the present value of the non-donor's survivor tenancy interest. It is equal to the difference between the present value of the retained interest based on the donor's and non-donor's joint lives and the present value of the retained interest based solely on the life of the primary tenant (donor).

Example: Continuing with the previous example, suppose the father names himself as the primary tenant and his son as the successor. The computation of the value of the son's successor income interest is as follows:

  PV of retained interest based on joint lives $176,543
Minus: PV of retained interest based on father's life $77,343
Equals: PV of son's successor interest - gift $99,200
Donor and Non-Donor Joint and Survivor Life Tenants

When the estate is retained by the donor and non-donor in equal shares for each of their lives with the decedent's portion retained by the survivor, the donor has, in essence, made two gifts: (a) the present value of the non-donor's right to receive a life estate in one-half of the property, and (b) the present value of retained interest for the tenants' joint lives in the remaining one-half of the property.

Example: Suppose the father names himself and his son as joint and survivor life tenants. While they are both living, each will have the right to the use of one-half of the property. When either dies, the survivor will receive the use of the entire property for his lifetime. The computation of the taxable gift to the son is as follows:

Gift 1 Computation

  PV of retained interest based on joint lives $176,543
Minus: PV of retained interest based on father's life $77,343
Equals: PV of son's successor interest $99,200
Times: .50
Equals: Gift 1 amount $49,600

Gift 2 Computation

  PV of retained interest based on father's life $77,343
Plus: PV of retained interest based on son's life $171,708
Minus: PV of retained interest based on joint lives $171,543
Equals:   $77,508
Times: 50%
Equals: Gift 2 amount $38,754
  Combined gift amount from 1 and 2 $88,354

Availability of Annual Gift Tax Exclusion

If all or part of the income interest is given to someone other than a spouse, the $10,000 annual gift tax exclusion is available only if the non-donor recipient has a concurrent (present) rather than consecutive (future) interest. If the non-donor tenant is not the donor's spouse, the annual gift exclusion can be increased to $20,000 with the consent of the donor's spouse. Any remaining taxable gifts can be further offset by the donor's unified gift tax credit.17

Marital Deduction

If the tenant is the donor's spouse at the time of transfer, the transfer will qualify for the unlimited gift tax marital deduction (provided the spouse or both spouses are the sole noncharitable tenants).18 The estate tax marital deduction will not be available, however, if the couple divorces during the term of the agreement.19

Power to Revoke Tenant's Interest

Can a donor forestall the recognition of a taxable transfer to a non-spouse tenant by reserving the power in the gift agreement to revoke their interest, thereby making the transfer incomplete for gift tax purposes?

Section 2511 of the regulations generally provide that a transfer becomes complete for gift tax purposes when the donor has relinquished dominion and control as to the disposition of property. When a donor reserves the power to revoke the donee's interest in property, such transfers are generally considered incomplete for gift tax purposes.

The Code, Regulations, and IRS have been silent with respect to the availability of a retained power of revocation for transfers of retained life estates. It seems reasonable, however, that based on the body of law applicable to other split-interest charitable transfers (e.g., charitable remainder trusts), that a retained power of revocation should be permissible.

All Donors Required to File Gift Tax Return

This may come as a surprise, but any person making a gift of a remainder interest in a personal residence or farm in any amount should file a federal gift tax return (Form 709) for the year in which the gift is made, even if no gift tax is due. The reason? Even though contributions of a remainder interest in a personal residence or farm to charity qualify for the unlimited gift tax charitable deduction under IRC §2522, charitable contributions of a partial interest are not one of the specific exceptions under IRC §6019 that relieves donors from having to file a gift tax return.20

Implementation

Unlike many other types of planned gifts, such as charitable remainder trusts and pooled income funds, the IRS provides no guidance with respect to the components of the life estate agreement. In order for the gift to be complete, the gift agreement must irrevocably transfer the property. This is accomplished by transferring title, usually by grant deed, to the charitable remainderman. Following are many of the issues that should be considered prior to transfer:

Obtaining Clear Title and Transferability

It is recommended that donors obtain a preliminary title report and/or opinion to 1) confirm the status of any encumbrances to which the property may be subject and to otherwise confirm that reconveyances attributable to previous encumbrances have been recorded; 2) verify the presence of any covenants, easements, or other agreements made by the donor that would prevent the transfer or sale of the property; 3) confirm that the zoning of the property is in compliance with its use; and 4) verify that the property is in compliance with building codes and free of any material defects that might affect or otherwise prevent its transfer to, or eventual sale by, the charitable remainderman.

Environmental Concerns

According to the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), an owner of property within the boundaries of a "Superfund" site may be held liable for the costs of cleaning up the site. State law may also apply. Since its original enactment, the law has been modified to indemnify charitable organizations from liability for the cost of cleanup provided the organization did not contaminate the property.

Even though charitable remaindermen of life estate agreements may be protected from CERCLA liability, the presence of any toxic hazard may adversely affect the charity's ability to ultimately sell the property. Accordingly, when even a remote possibility of an environmental hazard exists, an environmental audit should be performed prior to the charity accepting the property. A Phase 1 review researches prior owners and uses of the property. If the findings are suspect, a Phase 2 review includes physical inspection and core sampling.

The possibility of environmental hazards being present on personal residence properties is remote; however, with respect to farms, numerous potential toxic hazards exist. These include petroleum storage and exploration sites, and pesticides (e.g., livestock dipping areas).

Effect of Transfer on Property Tax Valuation and Transfer Tax Expense

Does the transfer of a remainder interest in real property trigger a revaluation for property tax purposes? If so, an increase in property taxes may discourage a donor from making this type of gift. Does the transfer of a remainder interest in real property trigger a transfer tax expense? If so, such cost should be considered prior to recording the Deed of transfer. The answer to these questions varies and must be confirmed with the taxing authority in the county or parish in which the property is located.

Possible Conflicts with Mortmain Statutes

Mortmain statutes have their origin in English law and were enacted during the Reformation to prevent ecclesiastical corporations (having unlimited life) from amassing through bequests all of the land wealth in the country thereby eroding the tax base. Today, some states have similar mortmain statutes. Will a contribution of a remainder interest in personal residence or farm qualify for federal tax purposes if the state has a mortmain statute that requires the charitable organization to divest itself of the property? Rev. Rul. 84-97 addressed this question. State X had a mortmain statute that required charities to divest themselves of properties received by bequest within ten years of receipt. The ruling held that because the charity is receiving a farm in its original form, and it can sell the property in the way that is most advantageous to it and will most likely realize its full value, the presence of the statute does not lend itself to abuse. The ruling held that the presence of a mortmain statute has no effect on the qualification of a gift of a remainder interest in a personal residence or farm.

Components of the Gift Agreement

As previously mentioned, property subject to a life estate agreement must be irrevocably transferred to charity. Following are the additional components of the agreement:

  • The agreement should define the measuring term of the retained estate. If the agreement is measured by the lives of one or more individuals, it should identify these individuals and the order in which they will receive their interests. If the agreement is measured by a term of years, it should also identify the primary tenant(s) and also provide direction regarding successor tenants should the primary tenant(s) die prior to the expiration of the term of the agreement.
  • The agreement should describe responsibilities to be retained by the tenant. These generally include maintaining the premises, insuring the property against loss and liability, repairing the premises in the event of damage, and prohibiting any additional liens or encumbrances to be secured by the property without the permission of the charity or permitting any existing lien or encumbrance to increase.
  • The agreement should also anticipate the possibility of the tenant vacating the property. If the property is to be rented or leased, the gift agreement can require that the charity join in the lease agreement in order to limit the period by which the lessee is permitted to occupy the property beyond the expiration of the measuring term of the retained estate. The gift agreement can also provide options for the sale of the property. These can include a sale and repurchase of a new property with continuation of the retained estate, a division of the proceeds in accordance with the value of each party's interest, or combination of the above.
  • Finally, the agreement should permit the charity access to the property for periodic inspection

Planning Opportunities

Life estate agreements are frequently contemplated by individuals who plan to spend their final years in their current residence. Circumstances and planning goals do change, however. What if the life tenant can no longer, because of age or health problems, maintain or occupy the property? What if the donor needs additional income more than they need an income tax deduction? What if the donor desires to make a remainder gift, but wants to also transfer a specific property to their heirs?

Rental of Property

The life tenant retains all beneficial lifetime rights in the property. This includes the ability to rent the property and receive the income therefrom. The gift agreement should contemplate this possibility and establish responsibilities for property management and maintenance should the life tenant vacate the property.

Selling the Property and Dividing Interests

Another option available to donor and charity is to sell the property and divide the net sales proceeds according to each party's interest at the time of sale. For this purpose, a present value of the remainder interest is calculated using the net sales proceeds and the date of sale. Any expenses, such as outstanding property taxes that would otherwise be attributable to the life tenant are deducted from the life tenant's share prior to distribution. The present value of the remainder interest is then distributed to charity with the remaining proceeds distributed to the donor. The donor will realize gain based on their proportionate share of the sales proceeds.

It should be noted that the gift agreement cannot compel the charity to sell its interest prior to the expiration of the measuring term stated in the gift agreement; to do so, according to Rev. Rul. 77-305, could defeat the charity's remainder interest in the residence itself.21 The decision to sell must, therefore, be voluntary on the part of both parties and not subject to a condition subsequent in the gift agreement.

Accelerating the Remainder Interest

Yet a third option involves the donor contributing the balance of the life estate thereby accelerating the gift of the remainder interest. In such cases, the donor is entitled to receive an additional charitable contribution income tax deduction based on the present value of their remaining life or term of years estate. For this purpose, the present value of the remainder interest is calculated using the fair market value of the property on the date the retained life or term of years estate is transferred. The present value of the remainder interest is subtracted from the fair market value of the property to produce the present value of the remaining life or term of years estate. This amount qualifies for charitable contribution deduction purposes.

Remainder Interest Split between Individuals and Charity

To this point, we have discussed gifts of the entire remainder interest to charity. Can a donor, however, split the transfer of a remainder interest in a personal residence or farm between charitable and non-charitable remaindermen? In Rev. Rul. 87-37, a taxpayer conveyed a 90-percent remainder interest in his residence to an individual and a 10% remainder interest to a public charity as tenants-in-common.22 In the ruling, the Service mentioned Rev. Rul. 76-544 in which it had previously addressed this question. That ruling held that gifts of remainder interests in personal residences or farms that vest in both a charitable organization and an individual, as equal tenants in common, are not qualified for income tax purposes because the entire remainder interest does not pass to charity.23

In reviewing the legislative history of the 1969 Tax Reform Act, the Service concluded that Congress did not intend that charity receive the entire remainder interest in non-trust gifts of a remainder interest in a personal residence. Indeed, IRC §170(f)(3)(B)(ii) allows a charitable gift for "an undivided portion of the taxpayer's entire interest in property." More importantly, the abuses the split-interest rules were intended to prevent with respect to charitable trusts would not be possible in this case because charity would always receive its proportionate interest. Rev. Rul. 76-544 was, therefore, revoked and the arrangement approved. The ruling did add that for purposes of determining the charitable deduction allowable, the value of the charitable interest must be reduced to reflect an appropriate valuation discount for the cotenancy arrangement.24

Planning Opportunity: This arrangement presents a creative planning opportunity for families that desire to keep a specific property, such as a vacation home, in the family. Using this technique, the parents transfer remainder interests in the vacation home to each of their children and to charity. The income tax savings produced by the charitable income tax deduction are then transferred to the children (or to a trust for their benefit). This amount is used to purchase a life insurance policy on the lives of the parents. Upon the death of the parents, the proceeds from the policy are used to purchase the charity's interest in the property.

It should be noted that the gift agreement or will of the donor cannot require the charitable remainderman to sell the property upon receipt. The Service has ruled that when such a requirement exists, the transfer of the remainder interest will not qualify for estate tax deduction purposes under IRC §2055 because it is not a remainder interest in a personal residence but, rather, the proceeds of a sale.25 Although the Service has not commented, it would seem plausible that the non-charitable cotenants could enter into an independent agreement with the charitable remainderman to purchase the charity's interest as described above. Any such arrangement would best be structured after and not as a condition of the gift. Advisors should proceed with caution.

Outright Gifts Combined with Gifts of a Remainder Interest

In Rev. Rul. 75-420, an individual donated a large vacation estate to a local college. In the deed of gift, the donor reserved the right for life 1) to the free and exclusive use of the property each year from August 1 through September 15; and 2) to store personal property at all times of the year in the storerooms in the principal dwelling house located on the property. The deed of gift further restricted the college from conveying the property until the donor's death or ten years after the execution of the deed of gift, whichever is later. During this time, the college is also restricted from making any structural or decorative changes to the property without the donor's consent. The ruling held that the donor had made a gift of remainder interest in the property with a retained life estate (as to the period of August 1 through September 15) and a gift of an undivided fractional interest in the property (as to the remaining portion of the year).26

Bargain Sale of Remainder Interest in Personal Residence or Farm

In many cases an individual's personal residence or farm represents a major component of their estate. Likewise, ideal candidates for life estate agreements are retired, may have modest income, and may be in need of or desire supplemental income.

In a traditional life estate agreement, the donor contributes the entire remainder interest in the property to charity. However, the donor is not required to do so. As an alternative, a prospective donor can offer to sell a portion of the remainder interest in conjunction with a contribution of the remaining portion. In such cases, the charity may offer payment in the form of cash, an installment note, or a charitable gift annuity (if available). In essence, the concept represents a sophisticated form of bargain sale.27

Because the purchasing charitable organization must make payment from sources exclusive from the contributed remainder interest, acceptable candidates for this technique are generally older and have property that is debt-free or significantly debt-free.


  1. Reg. §1.170A-7(b)(3)back

  2. Reg. §1.163-10T(p)(3)(ii)back

  3. Rev. Rul. 76-165, 1976-1 C.B. 279back

  4. Reg. §1.170A-7(b)(4)back

  5. IRC §170(f)(3)(B)back

  6. Reg. §1.170A-12(b)(2) and (3)back

  7. Reg. §1.170A-12(d)back

  8. Reg. §1.7520-3(b)(3)back

  9. Reg. §1.121-3back

  10. IRC §121(d)(8)back

  11. Ltr. Rul. 8615025back

  12. IRC §2522(c)(2)back

  13. IRC §2036(a)back

  14. IRC §2055(e)(2)back

  15. Rev. Rul. 76-473, 1976-2 C.B. 306back

  16. Technically, 120% of the Applicable Federal Mid-term Rate.back

  17. IRC §§2503(b); 2505(a)back

  18. IRC §§2056(b)(7) and 2523(f)back

  19. See also Ltr. Rul. 8742001 regarding the failure of a retained life estate to qualify for QTIP treatment or charitable deduction due to the presence of a condition subsequent that would terminate spouse's interest.back

  20. Reg. §25.2522(c)-3(c); IRC §6019(3)(B)back

  21. Rev. Rul. 77-305, 1977-2 C.B. 72back

  22. Rev. Rul. 87-37, 1987-1 C.B. 295; See also GCM 39628back

  23. Rev. Rul. 76-544, 1976-2 C.B. 288back

  24. See Estate of Fawcett v. Commissioner, 64 T.C. 889, 900 (1975), acq., 1978-2 C.B. 2back

  25. Rev. Rul. 76-543, 1976-2 C.B. 287; Rev. Rul. 77-169, 1977-1 C.B. 286back

  26. Rev. Rul. 75-420, 1975-2 C.B. 78back

  27. Ltr. Rul. 8806042back

Sample deduction calculation - 

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Comments

Re: Life Estate Agreements

"Further, because there are no rules that prohibit the life tenant from renting a personal residence during the term of their retained estate, it would also seem logical that the transfer of personal residence property that is rented in its entirety at the time of the gift should qualify."

Anyone have thoughts about this scenario:
Donors lived in residence A for 10 years then moved to residence B where they've lived 4 years during which time tenants have lived in residence A. Does residence A qualify for the RLE gift arrangement? Thanks.

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