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Why DOESN’T a Reserved Life Estate Get a Step-up in Basis under Internal Revenue Code Section 1022?

May 6, 2010

I’ve seen several blog posts this year that state the conclusion that a life estate is not entitled to obtain a step-up in basis upon the life tenant’s death in 2010, but I have yet to see any analysis on how those lawyers got to their conclusion.  Congress is well aware of the existence of life estates, as Internal Revenue Code Section 2036 specifically addresses them; if Congress intended to exclude life estates from receiving a step-up in basis under Internal Revenue Code Section 1022, it seems that Congress would have specifically mentioned them, as it did with several other common estate planning techniques.

To qualify for the step-up in basis under 2010 tax law, an asset must be considered to be owned by the decedent under Section 1022(d) and considered to be acquired from the decedent under Section 1022(e).  To determine whether a reserved life estate is entitled to a step-up in basis, the issue needs to be broken down into 2 questions.

Question 1:  At the time of death, does a decedent “own” the property which is the subject of a reserved life estate?

It is true that Section 1022(d) does not include life estates in its description of special rules on what is considered owned by the decedent, but life estates could be covered by the general rule.  Powers of appointment are less commonly utilized and not as well-known, but were expressly excluded under Section 1022(d)(1)(B)(iii), so Congress knew how to exclude certain planning techniques when it wanted to do so. If life estates were intended to be excluded, why were they not specifically mentioned?  A power of appointment is not a possessory interest, yet Congress took pains to exclude it from the possibility of a step-up in basis.  It seems illogical for Congress to have specifically excluded a nonpossessory interest but to be silent if it also intended to exclude a possessory interest such as a life estate.  Further, it is possible that the phrase “at the time of death” could be interpreted to exclude a life estate, because death terminates the interest, but since a reserved power of appointment was specifically mentioned and would also terminate at death, it doesn’t appear that the “at the time of death” phrase was intended by Congress to mean “after” death.  I therefore conclude that Congress must not have intended to exclude reserved life estates from the definition of what is owned by a decedent at the time of death.

I cannot speak for all 50 states, but under Massachusetts law, the life tenant has exclusive possession of the entire property during the life tenant’s lifetime.  The life tenant is entitled to all the rents and profits from the property and pays all current real estate taxes. Remainderpersons do not have the right to petition for partition because they do not have a present possessory interest in the premises.  At the time of the life tenant’s death, the life tenant has an ownership interest to the exclusion of the remainderpersons, and a reserved life estate may therefore fit the ownership test in Section 1022(d).

Question 2:  Does a remainderperson “acquire” from the decedent the property which is the subject of a reserved life estate?

If you agree with the analysis in Question 1, then this question probably poses little obstacle to the step-up in basis. The language in Section 1022(e)(3) includes “property passing from the decedent by reason of death to the extent that such property passed without consideration,” and where the property passes to the remainderpersons without consideration upon the life tenant’s death, that description could easily include a reserved life estate.  A question could arise on whether they received it “from” the decedent, but the possession does transfer based on the decedent’s actions.  The open issue on the step-up in basis would be whether, since the remainder interest was already vested, it was the entire value of the property that was “acquired,” or merely the actuarial value of the life estate at death; still, since the entire possession transfers upon the life tenant’s death, a strong argument could be made for the full step-up in basis (subject to the other limitations in the law of a total of $1,300,000 for most estates).

Conclusion:  It’s not an absolute slam dunk that life estates are entitled to a step-up in basis under Internal Revenue Code Section 1022, but there is at least a solid argument that they weren’t excluded and that they fit the definition of what is entitled to a step-up.

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11 Comments leave one →
  1. May 6, 2010 12:09 pm

    Brian:

    Very interesting analysis. If any clients, for whom I have drafted reserved life estates in years past, die in 2010, I will certainly borrow these arguments.

    Gene

  2. May 6, 2010 2:55 pm

    Brian,

    I agree with your conclusion, and I agree with your logic that if life estates were intended to be excluded, Congress would have specifically mentioned them. I made a similar argument in my detailed analysis of this issue that I wrote earlier this year entitled “Special Report on Tax Changes for 2010” — available at http://www.livingtrustplus.com/resources. Although my paper deals specifically with the topic of Income Only Trusts (the Living Trust Plus being a specialized type of Income Only Trust that I license to attorneys across the country), the logic is the same. As I stated in my paper:

    “The only mention of a trust [under IRC § 1022] in connection with property being ‘owned by a decedent’ is that property will be deemed to have been owned by a decedent if it was “property that the decedent transferred to a qualified revocable trust as defined in Code § 645(b)(1).11 Although there is no mention made of irrevocable grantor trusts, there is no reason to believe that Congress intended to eliminate the effect of IRC §§ 671-679. Specifically, under IRC §§ 671-679 and Rev. Rul. 85-13, if the decedent created a grantor trust, then for income tax purposes (and the § 1022 carryover basis rules are, of course, income tax provisions), it is ‘owned by the decedent.'”

  3. Don Solomon, Esq. permalink
    June 18, 2010 1:08 pm

    Interesting analysis, but I’m not optimistic that the IRS will agree with your position or NAELA’s. It would have been far preferable for Congress to say “property includible in the decedent’s gross estate for estate tax purposes” rather than “property owned by the decedent,” as section 1014(b)(9) provides. That would have tied it in with the requirement for filing a return in the first place. Since Congress did not do that, what reasoning could the IRS rely on to say that Congress must have meant it? I don’t think there is a general provision in the Code saying that “owned” always means “includible in the gross estate.” This is one area where legislative drafters usually say what they mean.

    I assume that if there were anything helpful in the legislative history of this provision, it would have been found by now. However, it might be interesting to research the Code provisions in effect prior to the 1970s, when the step-up rule was first adopted.

  4. John461 permalink
    September 1, 2010 12:56 am

    Very nice site!

  5. October 3, 2010 3:09 pm

    Hey there, thanks for info.I googled this issue and got only this page.Really helped me ! Farewell, Adam

  6. Bryan Jamison permalink
    November 2, 2010 11:57 am

    I have been struggling with this question all year. My opinion is slightly different; but, follows your logic.

    1. At the time of the death, the life tenant (of a reserved life estate) only owns the life estate part of the property. If the life tenant tries to sell the property, the table S (or Table R-2 for joint life estate) life estate charts are used to determine what share of the property the life tenant owns and what part is owned by the remainder persons. Those procedures and tables have been in place for several decades.

    2. Only the part of the ownership that is owned by the life tenant can pass at death to the remainder persons. The remainder persons already owned the rest of the property. If the remainder persons already owned part of the property, how can they argue that that part also transferred to them at the life tenant’s death?

    It is my position that because the life tenant only owns part of the property, that is the only part of property that is eligible for the basis adjustment. So, I believe that carry-over basis exists for the remainder portion and a basis adjustment is allowed for the life estate portion.

    I would like to trust Brian’s argument that when Congress did not expressly exclude life estates from 1022, that they implicitly included them. But, it is my position that the basis adjustment is only allowed if Congress specifically allows it. I only wish that Congressional negligence in failing to make the rule clear was a valid justification for me taking an aggressive position on my clients’ returns.

  7. Jerome Savino permalink
    December 5, 2011 2:57 pm

    Live in NYork. If you inherit a house through a conventional will, do you inherit the stepup in the value of the house so as to value the house at the time of death of the decedent?

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Trackbacks

  1. New Form 8939 Required to Be Filed with the Internal Revenue Service for Step-up in Basis for Estates of Persons Who Die During 2010 « Massachusetts Estate Planning, Probate & Elder Law
  2. Internal Revenue Service Releases 12/16/2010 Advance Proof Copy of Form 8939 Required for Step-up in Basis for 2010 Deaths « Massachusetts Estate Planning, Probate & Elder Law

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