Income Tax Issues With the Sale of Life Estates

A life estate agreement transfers property rights but allows people to remain in their homes until their death.

Life estates sales occur when a parent or older relative passes down real estate property title to a younger member or beneficiary. This frequently happens while the original owner lives in the property but wants to make sure the ownership get taken care of. Since the transfer generally reflects an increase in asset ownership by the recipient, taxes end up being owed on the value of the property. Folks planning a life estate should consult with a tax adviser before finalizing any tax-related decisions.

Tax Definition

Life estate interest: The original property owner retains the right to live in a property where the ownership has been transferred pending death.

Remainder interest: The recipient party, usually a relative, who owns title to a property but must accept the life estate interest holder living in the property until it is either completely relinquished or the life estate interest holder passes on.

Sales

Sales with No Life Estate: The prior owner must report capitals gains and remains subject to capital gains taxes that may apply on the equity gain in the house sold.

Sales During a Life Estate: Selling property connected to a life estate while it is in place requires agreement of both the interest holder and the remainder holder. As a result, the taxation on gain would be shared by both parties on their income taxes.

Sales After a Life Estate Liquidates: The property tax basis updates at the time it transfers completely to the remainder holder. As a result, when sold after transfer, the property gets taxed only on the gain from the time of transfer to the date of sale, not from the original purchase price. For example, a house bought for $20,000 gets transferred in a life estate, updating to a tax basis of $150,000. It then sells a year later for $160,000; the $10,000 difference equals the only gain taxed and reported on income tax filings.

Tax Reporting

Basis: The reportable basis of a life estate property equals the value of the house or property when it is transferred as a life estate, not the value of its original purchase.

Life Estate Gains: As a property gain resulting in increased income from a real estate sale, such profits are taxed as capitals gains at the capital gain rate. This income gets reported on normal income tax filings as a schedule attachment.

Tax Impact Areas

Gift tax: Whenever property or currency are transferred to another party without any exchange, the giving party remains liable for the taxable portion of the total amount. A certain value amount remains exempted per year (it was $12,000 in 2010).

Estate tax: With life estates, the life estate interest holder keeps the ability to stay in the house. As a result, on passing, total property title finally transfers to the remainder holder; this transfer triggers taxation as an estate tax (also known as inheritance tax).

Income tax: Gains in property value for life estate recipients only occur from the date of transfer. So any capital gains owed as income tax would be reportable on any sale after the life estate transfer for the basis gain since that date.

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