ESTATES AND TRUSTS

Transfers with a Retained Life Estate Part One: Gift Tax

By Robert E. Bertucelli and Richard A. Weinblatt

Viewed solely as a tax-saving transaction, a deed transfer with a retained life estate is of questionable benefit. The primary benefit of deed transfers of real property with retained life estates appears to be the protection of assets. Substantial benefits from a deed transfer with a retained life estate may be achieved, however, for the individual whose primary concern is the protection of assets against the cost of long-term nursing home care.

The use of a transfer with a retained life estate has been a common planning device for years. In many cases, a taxpayer will resist the recommendation, because of the normal desire to hold on to one’s assets. In some cases, this hesitation can be overcome by using a transfer that guarantees by contract the transferor’s right to continue to use the property after the transfer for a specified period of time or remaining lifetime.

Example

Mr. and Mrs. Tobias own a home jointly, purchased 40 years ago for $30,000. Since the date of purchase, they have made improvements to the property totaling $25,000. The home is worth $325,000 in today’s market, and the mortgage was paid off long ago. The couple has two children, both married, living nearby. Both husband and wife are retired, age 72, and in good health. They have other assets totaling $1.2 million, including a stock and bond portfolio, personal property, and insurance. They have started to focus on their estate planning but are concerned that they will outlive their financial resources.

Gift Tax Aspects

If the Tobiases transfer their residence to their children with a retention of a life estate in the property, they will have made a transfer subject to gift tax under the provisions of IRC section 2501. The IRC does not attempt to clearly define “gift,” but it has come to be recognized as the transfer of property where the dominion and control of the property is given up for less than adequate and full consideration. In this example, no consideration was received from the children upon the transfer of legal title to the residence. The giving up of dominion and control, however, is less clear. Does not the retention of the life estate result in an incomplete gift? In this type of transaction, Treasury Regulations section 25.2511-1(e) indicates that a taxable gift has been made because the needed dominion and control have been relinquished with respect to the remainder interest in the property. Because this is the only property interest being transferred under state law, all of the elements for a completed gift have apparently been met. This would be different, however, if the transferor retained sufficient powers over the transferred property (that is, the remainder interest), such as the right to change the beneficiary. This retention of the limited power of appointment would make the transfer incomplete for gift tax purposes.

Once the taxpayers have made a completed gift of the remainder interest, they calculate the gift tax liability, if any. The starting point is the fair market value of the property being transferred. Although the value might be adequately established by a local real estate agent, when the property is of high value the taxpayer should use a qualified appraiser and attach a copy of the appraisal report to the gift tax return.

The only property interest being transferred in this case is the remainder interest. The value of the entire property interest can be separated into income interest and remainder interest. The value of each can be determined by referring to tables found in the Treasury regulations. If the property was transferred prior to October 9, 1990, or if the transfer was transferred after that date but is not governed by IRC section 2702, this procedure will be appropriate.

IRC Chapter 14, comprising sections 2701 through 2704, was enacted in 1990 to replace IRC section 2036(c). Chapter 14 accelerates gift taxation where certain transactions are structured with family members in order to derive maximum tax advantage. IRC section 2702 applies in the case of a transfer to a family member where the transferor retains an interest in the property. When valuing the transferred property interest for gift tax purposes, the value of the retained interest is set at zero unless the retained interest is a “qualified interest.” This provision causes the transfer of the remainder interest to be valued for gift tax purposes at the same value as the entire property interest; that is, the income interest and remainder interest combined. A family member includes the transferor’s spouse, an ancestor or lineal descendant of the transferor or the spouse, any sibling of the transferor, and the spouse of any such ancestor, descendant, or sibling.

IRC section 2702 excludes transfers where the retained interest is a “qualified interest,” such as a grantor retained annuity trust (GRAT) or grantor retained unitrust (GRUT). Nor does it apply to the transfer in trust of the remainder interest in property to be used as a residence by the holder of the term interest, that is, the trust meets the requirements of a “personal residence trust.” This exception applies to both personal residence trusts (PRT) and qualified personal residence trusts (QPRT). The transfer of legal title to a residence where the deed provides for a life estate to be retained by the transferors is deemed to be a transfer in trust under the provisions of section 2702(c)(1). It could be argued that the existence of this imputed trust should be enough to allow for the exception under section 2702(a)(3)(A)(ii) to apply. The requirements under the regulations for a trust to be treated as a PRT or a QPRT are very specific, however, and are to be included in a formal trust document. The exception should not apply to a trust that is merely imputed. Thus, the value of the retained interest in this example would be set at zero.

If Mr. and Mrs. Tobias made the transfer determined under section 2702 in August 2000, when the applicable federal rate (AFR) under section 7520 was 7.6%, the value of the remainder interest alone would be approximately $105,000. Electing to look back two months for a more advantageous rate would reduce the amount of the gift to approximately $99,750. If section 2702 did not apply, this would be the amount of the gift instead of the market value of $325,000.

The next factor in determining the gift tax liability for the taxpayers is the annual exclusion available for transfers of property other than future interests (presently $10,000). The regulations define future interest as including “reversions, remainders, and other interests or estates … which are limited to commence in use, possession, or enjoyment at some future date or time.” Because the Tobiases intend to continue to occupy the residence until death, the interest that is being transferred is a future interest for gift tax purposes.

The transfer by deed of the residence with a retained life estate will therefore be taxed for gift tax purposes at the fair market value of the entire residence, without reduction for the value of the retained life estate and without the annual $10,000 exclusion.

If the transferor is married and the property is titled in the name of only one spouse, the other spouse can join the transferor spouse in making a split-gift election, which allows for the offset against both spouses’ unified credit. Having the spouses elect to gift split is generally not recommended for life estates because the entire value of the property, absent a subsequent inter-vivos transfer of the life estate, will be included in the transferor’s gross estate upon death. The transfer for gift tax purposes will be eliminated in calculating the adjusted taxable gifts when the estate tax is calculated, thus canceling any potential for double-taxation. If the transferor elected to gift split, upon the asset’s inclusion in the transferor’s gross estate, the IRC makes no provision for replenishment of the spouse’s unified credit [Ingalls v. Comm’r, 336 F2d 874 (4th Cir. 1964); Norair v. Comm’r, 65 TC 942]. If the spouse has very nominal assets and the desired gift tax deferral is needed, then the election may be appropriate; otherwise, it should be avoided.

Another gift tax issue is that if the transferors decide at a later date to transfer their life estates to their children or to any other party, they will have made another taxable gift. When the original gift of the remainder interest was made, because it was subject to IRC section 2702, the gift was calculated at 100% of the asset’s fair market value. Under a subsequent transfer, the total amount subject to gift tax could be well above 100% of the property’s total value. The regulations under section 2702 provide relief by allowing an offsetting reduction in the amount of the taxable gifts computed upon the second transfer. This reduction is the lesser of the value of the life estate at the time of retention or upon the subsequent transfer [Treasury Regulations section 25-2702-6(b)(1)]. If the transferor elected gift splitting on the subsequent transfer, one-half of the above reduction can be transferred to a consenting spouse.


Robert E. Bertucelli, CFP, CLU, CPA, is a professor of accounting and taxation at the CW Post Center of Long Island University and a partner of Bertucelli & Malaga, LLP, Hauppauge, N.Y. He was this year’s recipient of the Emanuel Saxe Award as the Outstanding CPA in Education.
Richard A. Weinblatt, Esq., CPA, is a partner of Haley Weinblatt & Calcagni, LLP and co-chair of the Elder Law Committee of the Suffolk County Bar Association.

Editor’s Note: This is the first in a two-part series discussing the planning opportunities afforded by deed transfers with a retained life estate. The second part will run next month.

Editors:
Lawrence M. Lipoff, CPA
Deloitte & Touche LLP

Susan R. Schoenfeld, JD, LLM, CPA
Bessemer Trust Company, N.A.

Contributing Editors:
Jerome Landau, CPA

Debra M. Simon, MST, CPA
The Videre Group, LLP

Richard H. Sonet, JD, CPA
Marks Paneth & Shron LLP

Peter Brizard, CPA

Ellen G. Gordon, CPA
Margolin Winer & Evens LLP

Jeffrey S. Gold, CPA
Joseph R. Beyda & Company P.C.

Harriet B. Salupsky, CPA
Weinick Sanders Leventhal & Company LLP


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