A recent Tax Court case is a useful reminder about the estate tax treatment of life estates. The tax rule involved has been in place for decades: if you give away an asset but retain the use of the asset for your lifetime you will be treated as the owner of the asset at your death for estate tax purposes even though you no longer own the asset.
The case in question, Estate of Trombetta, involved a taxpayer who transferred her residence to a trust of which she was the sole beneficiary and trustee during her lifetime. She also transferred 2 rental properties to another trust in exchange for a 15 year annuity. She was a co-trustee of the second trust and continued to manage the rental properties. The trust permitted the trustees to distribute the trust’s excess income to the taxpayer in addition to the annuity payment. The Tax Court concluded that all three properties were includible in the taxpayer’s estate for estate tax purposes at their date of death value because the taxpayer continued to enjoy the properties in the same manner and to the same extent as she had before she transferred ownership to the trusts.
Life estates only create the potential for adverse estate tax results if your total assets, including the property in which you’ve reserved the life estate, exceed the applicable federal or state estate tax exemptions in effect at your death. That is not the case for the majority of the public. As a result, life estates still play an important role in Medicaid/Mass Health planning notwithstanding their potentially adverse estate tax treatment, and in this context can also provide an income tax benefit.
A commonly used Medicaid planning strategy involves transferring ownership of your principal residence to your children during your lifetime but retaining a life estate in the property. The life estate gives you the exclusive right to use the home as your residence for your lifetime. Under current law, any lien that Mass Health imposes on the home while you are receiving benefits will expire as of your death since that is when your life estate disappears. In addition, your basis in the property will be “stepped-up”—i.e., increased– to the property’s fair market value as of your death for income tax purposes as a result of retaining a life estate in the property. This will allow your children to sell the property after your death for little or no income tax cost.
Life estates can arise in other circumstances, not all of which create adverse estate tax results. For example, life estates that others create for you, such as a trust that your parents might create for your benefit for your lifetime, generally will not be subject to estate tax at your death assuming you do not have significant control over the trust assets. On the other hand, life estates that you create for your own benefit in property that you have otherwise given away generally will be subject to estate tax.
Finally, the Tax Court has issued a number of decisions involving indirect life estates, many of which involve vacation homes. These cases typically involve situations in which the owner of the property gave it away to his children, or a trust for the benefit of his children, and did not retain a life estate or any other express rights in the property. However, the owner continued to use the property on a regular basis after the gift without paying rent. The Tax Court has consistently held that the original owner’s regular and continuous rent-free use of the property after the gift was tantamount to a life estate, resulting in the property becoming subject to estate tax at the owner’s death.