Creating a life estate lets you transfer a home to a beneficiary without selling the property. To qualify as a life estate, both you and your beneficiary must be listed on the deed. You retain the right to live in the home until you die, and the beneficiary has a remainder interest in the home.
Upon your death, the home automatically transfers to the beneficiary. Since the Internal Revenue Service taxes the transfer as though the home had been sold, this can create tax issues on your final tax return, your estate return and for your beneficiary.
Estate Tax Liability
The IRS treats the life estate transfer as a sale, and the fair market value of the house is included in your estate. If your estate exceeds the exclusion amount, you could owe estates taxes on the difference. As of publication, the estate exclusion amount is $11,400,000. Any excess amount is taxed using a graduated tax scale.
For example, if your estate is $10,000 or less over the exclusion maximum, the excess amount is taxed at 18 percent. If your estate is $100,000 to $150,000 over the exclusion maximum, the amount is taxed at 30 percent.
Individual Tax Liability
When you die, the ownership of your home passes from you to the beneficiary listed on the deed. The amount of tax you pay on your individual tax return is based on what the house would sell for on the open market. This can potentially step up the value of your home.
The basis is the difference in price between the home’s original purchase price and its full market value at the time of your death. The gain or loss is reported on Schedule D, Capital Gains and Losses, and is disclosed on your individual tax return.
Beneficiary’s Capital Gain
The life estate beneficiary’s basis in the home is its fair market value at the time of your death. Depending on your state’s laws, your beneficiary can live in the home as a residence and claim homestead exemption on the property. If your beneficiary sells the home without living in it, any gain on the stepped-up basis is taxed as a capital gain.
Should your beneficiary keep the house and rent it out, she can treat this activity as a business enterprise. In this case, the expenses offset the income, and the beneficiary is taxed on the net amount.
Gift Tax Exclusion
You can use your gift tax exemption to transfer the home tax-free to the beneficiary in a phantom sale. As of publication, you can make a tax-free gift worth up to $15,000 annually for as many beneficiaries as you like. For example, if the sale price of your home is $150,000, you can give a $15,000 tax-free gift for the next 10 years and eliminate any potential tax liability for your beneficiary. If you own the home jointly with your spouse, you can give a joint $30,000 annual gift so the home passes to your beneficiary tax-free in five years.
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