Sale of the house with a life estate

[ElenaVAN]

What is the name of your state (only U.S. law)? Wa state

My husband lived with his father since 2001. In 2006 his father transferred the house to my husband, but reserved a life estate. In 2009 we sold the house (on the closing date my father-in-law released his life estate). To be qualified for capital gain tax exclusion of $500 000 we meet the use test. The house was our main residence for more than 2 years prior to sale. Do we meet the ownership test?
Thank you, Elena

 

[FlyingRon]

This is an interesting question, but I believe you do meet the ownership test. The IRS considers your remainder interest to be a partial ownership interest and hence you do meet the ownership requirement (and if you've lived there 24 out of the previous 60 months, and you've not used the exclusion in the two years prior to the sale you qualify).

Of course, hopefully dad doesn't have to get medicaid before 2016 as you've probably screwed that up.

Your basis is his basis (presumably low, if he's owned the house for a long time).

 

[HappyWanderer]

You can't "release" a life estate. It is an interest in the property. A gift tax should have been completed on the original transfer (unless FMV was paid) and, it is unclear what happened at the time of the sale. Unless a true transfer by deed was made to you, I'd say dad sold his portion and you sold yours of the property. The split needs to be calculated. In the alternative, you might be able to argue there was a gift of the property to you (along with another gift tax return) but, could you then argue you "lived" in the portion transferred? There may need to be an allocation of value between the retained "life" estate and the remainder.

I think you need to see someone who can review the facts and look up case law, letter rulings and other substantive information. You have a pretty complex situation.

The publication 529 says you may exclude the gain on the sale of a remainder interest as long as you don't do the same to any other interest sold separately. (I know this was sold at the same time. But, if so, we have the gift issue to deal with.)

 

[FlyingRon]

You can't "release" a life estate. It is an interest in the property.

Surely you can. You release it by deeding it away and the IRS uses the term "release" for that specific act, so it's not even a terminology quibble.

Yes gift tax filings are due.

There are three acts here:

The original gift.
The gift of the remainder interest.
The sale of the house.

As far as the capital gains exclusion goes, the percentages apportioned and all that don't much matter. Dad appears to not be taking proceeds from the sale since he's already relinquished the remainder interest. The only question is if the partial ownership of the property with the life estate created an ownership interest for the couple who want to use the exemption, and I believe they do.

There's no requirement to tie the USE of the property to the OWNERSHIP of the property. As a matter of fact, the code specifically provides for the opposite.

You've had to have at least partial ownership for 24 months.
You've had to have lived there 24/60.
Those don't even be the same 24 months.

I agree, it would behoove you to bring this to someone more well versed in things than me and Happy (unless Lidj shows up to break the tie).

 

[HappyWanderer]

While I don't specifically disagree with anything FlyingRon just wrote, I believe it still unclear the status of the life estate interest. There were two things sold. The remainder and the life estate. They don't merge until the measuring life ends. While the ownership and use tests do not have to be concomitant, they do both have to be for 2 of the last 5 years.

Unless you have a citation regarding the sale of the life estate the OP did not own for the time required by Section 121 I'd think it best he see someone who will look things up.

There is a lot of stuff out there on the reverse happening. (Sale and the split between life estate owner who 121 applied and the kid who didn't live there.) It seems like a bit of calculation will need to be done first. As you implied, a lot of this comes up in the medicaid arena.

 

[ElenaVAN]

I appreciate your advices very much.
My father-in-law transferred house to my husband in 2006, and in 2007 we filed a gift tax return (form 709). At the time of sale of the house in 2009, my father-in-law relinquished his life estate (the real estate attorney drew the deed for us). None of the proceeds went to my father-in-law.
About medicaid... My father-in-law had a stroke in 2004 and since then my husband has been taking care of him (my father-in-law is disabled and need 24 hour assistance). Under medicaid rules the parent can transfer house to the child without penalty, if child has lived and cared of parent for the period of two years immediately before the date of applying for Medicaid
Thank you

 

[HappyWanderer]

See also:

http://www.bovelanga.com/publications/news_briefs/trusts_and_estates_forum/Trusts and Estates The Meaning of Life.pdf

 

[HappyWanderer]

Another thing to look at is Letter Ruling 200104005.

I think section 121 will NOT apply to the life estate portion of the sale as the "ownership" requirement won't be met.

 

[LdiJ]

I agree with Flying Ron on this one.

I had to research this exact scenario for one of my master's classes, just a few years ago.

They get the exclusion. They lived in the home more than 2 of the last 5 years, and they meet the ownership test. It actually is NOT necessary to own it for more than two of the last 5 years. Its only necessary to have owned it at the time of sale and for it to have been your principal residence for two of the last 5 years.

Another example would be the following: Adult child lives with his/her parent for 10 years. Adult child inherits the home when the parent passes, and a year later decides to sell it. Adult child gets the full exclusion because they met both the residence test and the ownership test.

 

[HappyWanderer]

§ 121. Exclusion of gain from sale of principal residence
(a) Exclusion
Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.

Since you have researched this in your master's program, I'm sure you have a TON of citation's for your opinion. I supplied a letter ruling that seems to say something different. I'd love the substantive authority for the example you cite.

(If you're talking about the example in the regs at 1.121-4 Special rules at (A)(2), do you really want me to distinguish it?)

Are you saying the code only requires ownership at sale and not 2 years of ownership? If so, I'll spend a couple of seconds to give a response with citations.

 

[ElenaVAN]

I totally agree that to meet ownership test we must own the house for 2 years within the look back period of 5 years prior to sale.
Here's part from US Code, Title 26 §121:

(8) Sales of remainder interests
For purposes of this section—
(A) In general
At the election of the taxpayer, this section shall not fail to apply to the sale or exchange of an interest in a principal residence by reason of such interest being a remainder interest in such residence, but this section shall not apply to any other interest in such residence which is sold or exchanged separately.


To my understanding if house was transferred in 2006 and my husband was owner the remainder interest for more than 2 years, we do meet the ownership test.

 

[HappyWanderer]

A few things. First, let LdiJ respond as she seems to know taxes very well. Perhaps there is some type of merger and tacking going on here one can argue to the IRS. Most papers on a master's program would not have a clear answer and you never know what creatively weaving the facts together can do.

Second, I think the code you quoted is not quite on point as it is designed to only allow one 121 exemption per the sale of property when related to other interests. I mentioned this with:

The publication 529 says you may exclude the gain on the sale of a remainder interest as long as you don't do the same to any other interest sold separately.

This is more to prevent a person stripping equity. In other words, you and your wife having over $500K in gain in the property and, to avoid all taxes, you create a life estate, sell the remainder now and then selling the life estate to the same entity/person later and essentially getting a 121 double dip on the same property.

Finally, I think we all believe you get the 121 exemption on the remainder interest in the property. The question arises on the life estate portion of the property.

 

[LdiJ]

A few things. First, let LdiJ respond as she seems to know taxes very well. Perhaps there is some type of merger and tacking going on here one can argue to the IRS. Most papers on a master's program would not have a clear answer and you never know what creatively weaving the facts together can do.

Second, I think the code you quoted is not quite on point as it is designed to only allow one 121 exemption per the sale of property when related to other interests. I mentioned this with:
This is more to prevent a person stripping equity. In other words, you and your wife having over $500K in gain in the property and, to avoid all taxes, you create a life estate, sell the remainder now and then selling the life estate to the same entity/person later and essentially getting a 121 double dip on the same property.

Finally, I think we all believe you get the 121 exemption on the remainder interest in the property. The question arises on the life estate portion of the property.

I cannot provide the cites, I do not still have the material and I honestly do not have time to research it again at this time of year (unless I had a paying client of course). Most of the cites for the research came from case law rather than letter rulings.

However, even if the quoted items are accurate now (they tweak things enough that something could have changed) they HAVE owned the property in this scenario for more than 2 of the last 5 years, so I don't thinks its a problem.

I do understand the concern over the life estate, but a life estate concerns the right to occupy the property. Yes, there are often valuations made to life estates, but in all other factors the remaindermen are treated as if they completely owned the property as of the date of transfer. They get no stepped up basis on the value of the life estate etc.,

 

[HappyWanderer]

We KNOW with complete assurance if the facts were reversed we would need to do the calculation. Cases, letter rulings, regulations and examples--period.

And, by reverse I mean the usual way in this type of situation where the parent lived at the property and the kid did not and the question had to do with lived in and not ownership for 2 of the last 5 years.

While the letter ruling I posted had to do with a virtual "life estate" as created by trust, I believe it applies here too.

I wanted to check something out before writing, and found the following article which discusses the issue extensively:

Medicaid Planning with Life Estates

While it does not specifically answer our question, it clearly seems to treat the life estate as a separate thing where section 121 exclusion is available--IF the section's requirements are met.

I don't think the deeded life estate in this discussion has met the requirements of 121 and capital gains should apply. However, depending on dad's age, the section 7520 calculation may make the value of the life estate quite small.

 

[FlyingRon]

It doesn't matter what the life estate is valued at. As long as there is some fractional ownership assigned to the kids for at least two years, they can use their exemption. There's no carving up or proration of the exemption based on ownership. Every fractional ownership who also meets the use test can claim their full $250,000 against whatever gain they have. At the time of the sale, the remainderman is out of the way, so all the gain is apportioned to the children.

The only thing that trying to ascertain the relative values of the property and the life estate is for the gift tax (a moot point because I suspect while
both gifts are greater than the annual exclusion the father probably didn't hit his aggregate lifetime exclusion). Second both transfers are at this point
inside the medicaid lookback. Things only get sticky between 2015 and 2020 where you have to figure out how much the remainder gift should be valued
at.