Life Estate Can Be “Retained” for Estate Tax Purposes under Internal Revenue Code Section 2036 without Being Reserved in Deed
NOTE: This article reflects the current 2011 law, and also reflects pre-2010 law. It also is the default provision for decedents who died during 2010 unless the executor chooses to have 2011 law apply.
For many elderly persons in the middle class, a key tax goal is to keep the home includible in the person’s gross estate for federal estate tax purposes. Doing so results in a step-up in the basis of the home under Internal Revenue Code Section 1014, and the persons inheriting the home essentially receive, free of any capital gains tax, the appreciation in value from the time of the initial purchase of the home.
For example, suppose a person who paid $10,000.00 for a home dies when it is worth $200,000.00. The appreciation of $190,000.00 escapes capital gains tax if the home is includible in the person’s gross estate for federal estate tax purposes.
For a person who wishes to give away the home, the most common method of doing so may be to give away the remainder interest while reserving a life estate. Internal Revenue Code Section 2036 states that “the gross estate shall include the value of all property… of which the decedent has at any time made a transfer… under which he has retained for his life… the possession or enjoyment, or the right to the income from, the property.” Thus, if the person deeds the home to others, yet explicitly reserves a life estate, the full fair market value of the home is includible in the client’s gross estate for federal estate tax purposes and the transferees thereby receive the desired step-up in basis.
Unfortunately, some persons deed away their homes without reserving a life estate. Arguably, the federal estate tax inclusion ends up being lost by such a maneuver, but the literal language of Section 2036 quoted above can salvage the step-up in basis: note that the word “retained” is used. The Internal Revenue Service has successfully argued in the past that a right can be retained without having been reserved, and that the continued occupancy of the home after the transfer of title, without paying fair market rent, is evidence of an implicit agreement, understanding or assumption of the parties of the transaction. (See Estate of Linderme v. Commissioner, 52 T.C. 305 (1969).)
For example, if a person deeds the same home described above but reserves a life estate, upon the person’s death the home is includible on the Federal Estate Tax Return and the transferees receive a stepped-up basis of $200,000.00. If the person making the transfer had not reserved the life estate, but continued to live there rent-free or for less than fair market rent, the home should be included on the Federal Estate Tax Return as a “retained life estate” if a step-up in basis is desired.
One final note: under Internal Revenue Code Section 2035, a release of a life estate is ineffective for federal estate tax purposes for three (3) years. This means that a life estate that is released within three (3) years of death is included in the gross estate and results in the desired step-up in basis. Thus, if a person insists on making an outright transfer (perhaps due to Medicaid estate recovery concerns), it may be better to structure the transaction as a deed with a reserved life estate, then have the person release the life estate at a later time.
Massachusetts Estate Planning, Probate & Elder Law 
I represent the executor of a decedent who died in 2010. I believe we have a strong case , based upon your information, for a “retained” life estate and consequently a step-up in basis(which my client hopes to attain). Of course, a Federal Estate Tax return is unavailable for 2010. My question is how to obtain the step-up when the gross taxable estate does not reach the threshold amount for filing?
My mother passed away in 2010. Our lawyer indicated to us that this new law does not pertain to our situation.
Our family farm was in my Dad’s name only. When he died in 1977, the farm was inherited by the children. My Mom was given the right to the income for as long as she lived through a life estate that became effective upon his death. She never owned the farm. In 1978, she paid a large inheritance tax on behalf of the children. When she died, the children gained control of the farm. The farm was sold in 2010 soon after her death. The difference between the 2010 value and the 1977 value became a capital gain. The tax laws in 2010 had no bearing on this outcome. A capital gain was to be recognized regardless of which year she died.
If my Mom had jointly owned the farm at the time of his death, she would have received full ownership of the farm without having to pay any inheritance tax in 1978. Then when she died, the life estate could have been rescinded. With the farm in her estate, the value of the farm could have been stepped up. Estate taxes and capital gains taxes would have both been avoided.
I set up a GRIT 17 years ago and on Dec 19, 2010 my home was transferred to my 2 sons. Wife & I have been paying fair market rent since then. Until the Feds decide on the exemption (which is now 5 million each) I will continue the fair market monthly rent payments.
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If the final (permanent?) exemption is more than our net worth including the home, I think I should reduce the monthly rent down (to less than fair market rent) to where the rent equals my sons expenses etc, which means they pay no income tax on the rent income. What are the ramifications if I do this?
Based on your “Life Estate Can Be “Retained” for Estate Tax Purposes under Internal Revenue Code Section 2036 without Being Reserved in Deed” would this “less than fair market rent” put the home back into our estate after the death of my wife and I? If so then my sons get it at a stepped-up basis. This sounds to good to be true. Your comments would be greatly appreciated.
Thanks, Larry
Sorry, but this is a blog, and is not intended to give advice to anybody. You should obtain specific advice geared to your own particular situation from an estate planning lawyer in your state.
Interesting Blog! Good to know more about estate tax that am not aware of…
Keep updating…