September 26th, 2022
Recently in the Tax School Facebook private group, an interesting question was raised regarding the transfer of real estate when an interest in the property is retained. The question concerned how the beneficiaries holding a remainder interest should treat the sale of property after the individual holding an implied life estate passes away. For example, are the beneficiaries required to report the sale of the asset, which is typically real estate? This issue has implications for the beneficiaries’ income tax returns and raises the question of whether a late gift tax return should be filed.
This is not an uncommon situation. An elderly taxpayer often adds their children to the deed for their residence. This action may be taken for the sake of convenience, wanting to be expedient in transferring assets after death. Everyone in the family understands that even though the children technically own shares of the residence, their mom or dad will continue to live in the home until she or he passes.
Let’s say that they fail to ask an attorney to draw up the paperwork, so there is no formal documentation of the life estate. But the adult children treat the property consistently with the understanding that the parent has possession of the residence and is responsible for the costs associated with living in it. The family may ask the following questions.
A life estate is the continued possession of property during one’s life while at the same time transferring it to another party or parties. Thus, the party living in the house or possessing the property has a tenancy for an uncertain time, but they cannot sell it. Instead, they have given a future interest in the property to another beneficiary, who can take possession after the death of the tenant, who in our context is the parent living in the house. The parent gives a future interest in the property to their children because they do not take ownership until the parent passes away.
A hypothetical example illustrates this. Consider a married couple, Tom and Carol, who purchased their home in 1978 for $65,000. They occupied it continually until 2012 when Tom passed away. Carol continued to live in the house after Tom’s passing but, in 2013, decided to add their five adult children to the title. She did not consult with an attorney before undertaking this action, so her life estate in the residence was never formalized. Her will designates one son, Steve, as the executor of her estate with the power to file any necessary tax returns.
All the children were close to their mother, and they shared the understanding that she would live in the family home for the rest of her life. Each adult child had their own home. Carol passed away in mid-2015, and the children sold the house to an unrelated person in September of that year for $350,000. During the following January, each adult child received Form 1099-S, Proceeds from Real Estate Transactions, showing gross proceeds of $70,000, representing their 20% share of their mother’s residence. Each of the adult children should include the information from Form 1099-S on their individual income tax return, along with the house’s value as the basis. If they overlook this, the IRS will likely send correspondence regarding it.
In this example, each of the children receives a future interest in the property when Carol puts their name on the deed. Thus, the conveyance of the future interest in the property is a gift that should be reported on a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. While most gifts do not need to be reported if they are less than the annual exclusion, the exclusion does not apply to gifts of future interests. As a consequence, even if a beneficiary received an interest in the residence having a fair market value (FMV) less than the annual exclusion amount, a gift tax return should be filed.
In our example, no formal document established Carol’s life estate, but she and her five children all acted as though the life estate existed. Fortunately, the U.S. Tax Court provided credibility to these arrangements in which no formal life estate documentation exists. This case was decided more than 50 years ago. In the absence of formal written instruments, a life estate may still exist under certain conditions as an implied life estate.
In the Guynn case, the IRS wanted to include the mother’s residence in the estate of the decedent’s estate. Mrs. Calvert purchased a new home approximately two years before her death to be near her daughter, Jane Guynn. Mrs. Calvert designated Jane as the executor of her estate. Wanting to make a gift to her daughter, Mrs. Calvert asked the sellers to deed the property to her daughter, which they did and which Mrs. Calvert also signed and recorded. In an attempt to reduce estate tax, Jane Guynn appealed an unfavorable judgment of a lower court that decided the residence should be included in the mother’s estate, even though the future interest was transferred. The transfer was also documented in a Form 709 gift tax return.
When Mrs. Calvert died in 1963, the estate tax exemption amount was only $60,000 (in 2022 this exemption is $12,060,000). The IRS contended that just by living in the property, Mrs. Calvert fulfilled the requirements of IRC §2036, so the value of her house should be included in the estate. So even though a Form 709 gift tax return was filed to reflect Mrs. Calvert’s gift to her daughter, the IRS won its case in the appellate court to compel the inclusion of the property given to Jane in Mrs. Calvert’s estate.
Looking at just this one case, the IRS won its battle to include more assets in a decedent’s estate. But it likely did not contemplate how a much higher exemption amount would affect this calculation. In fact, by forcing the inclusion of gifts made within the three years before death, the IRS facilitated the application of IRC §1014 to life estates. So in some way, taxpayers got the last laugh on this.
But one case does not make a doctrine. Each case presents its own facts and circumstances, and given the IRS’s desire to include assets in an estate, it seems likely that the implied life estate will continue unless Congress intervenes. And there are some circumstances that can compromise the inclusion of assets in a life estate. The forthcoming 2022 University of Illinois Federal Tax Workbook discusses these circumstances, including a three-factor test that provides guidance for when assets are included in an estate under IRC §2036. This will be discussed during this year’s Fall Tax School, as well.
If Carol did not file a Form 709 gift tax return when she added her children to the title, one should be filed for her, even though it will be filed late. Because she gave her children a future interest in her residence, a gift tax return was required, even if the value of each child’s share was less than the exemption amount. This provides a trail that establishes that the assets were given to the adult children and that the assets’ existence is not the result of untaxed income.
Steve should consider whether state or federal estate tax returns are required. Given that the federal exemption was over $5 million at her death, it’s unlikely Steve will have to consider this for very long. However, many states have lower thresholds for filing estate tax returns, and there is some possibility that a state-level estate tax return may be required. A few states have inheritance taxes for which Carol’s adult children may be individually responsible.
Using a stepped-up basis for assets an elderly person continues to use until their death generally works out well because IRC §2036 places assets in a decedent’s estate. But the application of this Code section depends on the satisfaction of three tests. These tests will be discussed in this year’s Fall Tax School in a section entitled “Tax Consideration in the Distribution of Estate Assets.” This section of the 2022 Fall Tax School discusses many aspects of the tax issues arising from the distribution of estate assets, including those that may or may not support the existence of an implied retained interest.
Treas. Reg. §25.2503-2(a). In 2022, the annual exclusion is $16,000.
Jane C. Guynn, Executrix of the Estate of Vena E. Calvert, Deceased v. U.S., 437 F.2d 1148 (4th Cir. 1971).
How many people pay the estate tax? 2022. Tax Policy Center. [www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax].
By John W. Richmann, EA, MBA
Tax Materials Specialist, U. of I. Tax School
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