A life estate allows someone to live in a house until their death. It’s also known as “life rights” to a home. The life tenant of the home, the person retaining the life estate, places the name of his beneficiary on a life estate deed. That beneficiary is known as the “remainderman,” and is the co-owner. When the occupant dies, the home is automatically transferred to the co-owner on the deed, and the life estate per se ends. While situations vary, life estates usually name a family member as the beneficiary. As the American Bar Association puts it, “Life estates are estate planning devices that vest title in a surviving spouse who is usually spouse number two, and upon that person’s death, the property goes to the children of the original owner.” Understanding life estate deed tax implications is critical for those who are beneficiaries in such arrangements.
In general, income tax issues which occur as a result of the sale of a life estate typically involve capital gains. Thanks to generous exclusions provided by the IRS, it is quite possible that an individual can sell a life estate without incurring a large tax bill.
Finding More About Capital Gains
What if the life tenant and beneficiary commit to the sale of life estate property basis ? The IRS permits homeowners to exclude up to $250,000 of capital gains on the sale of a home for a single filer, and up to $500,000 for a married couple filing jointly. That capital gains exclusion doesn’t usually include life estates if the property is sold. The exclusion requires that a seller owned and lived in a home for at least two out of five years before the sale. Instead, if the life tenant is still alive, the IRS uses an actuarial formula based on the life tenant’s age and life expectancy to determine the capital gains tax. If you each own half of the property and your capital gains was $100,000, you would each owe capital gains taxes based on half-ownership, or $50,000.
The life tenant and remainderman may owe state taxes on the capital gains sale of the property. Some states do not have a capital gains tax, and the rate varies greatly for those states that do tax capital gains. Much also depends on the state tax brackets of the sellers, which affects the rate on capital gains.
Looking Closer At The Step-Up Basis
If the life tenant dies, the remainderman receives the property on a stepped-up basis. That means that it is valued as of the life tenant’s death for capital gains purposes when sold, not the amount of money the life tenant paid for it. For example, if the property is worth $400,000 at the time of the life tenant’s death and is sold for $415,000, the remainderman pays capital gains taxes only on the $15,000 overage. If the home is sold while the life tenant is still alive, there is no step-up basis. The capital gains is determined by what the life tenant originally paid, say $200,000, and the sale price, making the capital gains $200,000.
Obtaining Information About Medicaid Triggers
A life estate deed automatically triggers the Medicaid five-year look-back period. If the life tenant applies for Medicaid, she is asked if any transfers were made to other people within the past five years. Any such transfers made within those five years may be divested for Medicaid purposes. That’s why the creation of a life estate requires the use of a knowledgeable elder law attorney who can help with all relevant life estate tax questions.
You can use Schedule D of IRS Form 1040 in order to report any capital gains that you may have obtained through your role as a beneficiary. It is critical to report these transactions as accurately as possible in order to avoid federal scrutiny and possible penalties.
- IRS: Topic Number 701 - Sale of Your Home
- IRS: Actuarial Values
- Elder Needs Law: Life Estate Deed and Income Txa Issues
- Elder and Disability Law Center: Medicaid Myths
- Washington State Health Care Authority. "Life Estates." Accessed Aug. 1, 2020.
- American Council on Aging. "How Lady Bird Deeds Protect a Medicaid Recipient’s Home for Their Loved Ones." Accessed Aug. 1, 2020.
- University of Maryland College of Agriculture and Natural Resources. "The Life Estate Deed—Look Before You Leap!" Accessed Aug. 1, 2020.
- The People's Law Library of Maryland. "Life Estates." Accessed Aug. 1, 2020.
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including Sapling, Zack's, Financial Advisor, nj.com, LegalZoom and The Nest.