Use of a Life Estate for Personal and Charitable Benefit

A homeowner or the homeowner’s family is often faced with the prospect that the homeowner’s estate will have to sell the property to raise the money to pay the estate taxes due if the property is included in the owner’s estate.  By making a gift of the property to a qualified charity with a reserved “life estate,” the owner of a personal residence or family farm can preserve the use of a property for the owner, spouse and/or children for an extended period of time.  In addition, by making a transfer to a qualified charity during your life, rather than waiting until your death, you may be entitled to take an income tax deduction that you can enjoy while you are alive, yet still retain the ability to use the property throughout your life.

The estate tax is based on the fair market value of the property as of the owner’s date of death (or the 6-month anniversary date), currently at a tax rate of up to 50%.  Because it may not be possible to pay the estate taxes due from the other estate assets, it may become necessary to sell the home to pay the taxes.  Although it may be financially impossibly to keep the property, it may also be psychologically impossible to part with the property, whether it be the historic family farm or a beloved home.

A person who wants to leave their home to a favorite charity can, or course, do so under the person’s Will.  But, by making the contribution under the person’s Will rather than making the contribution while the person is alive, the person will lose the opportunity to enjoy an income tax deduction and may never know the pleasure that the gift has given to the charitable beneficiaries.

For persons who wish to make a charitable contribution of their property to a nonprofit organization, wish to retain the use of the property during their lifetime, and would benefit from an income tax charitable deduction, the use of a life estate can be the perfect tool.

A life estate is created when a property owner gives the property away but reserves the right to reside in the property for the owner’s life or for the lifetimes of the owner and the owner’s spouse and possibly even children’s lives.  By making a gift of the remainder interest in your personal residence or family farm to a qualified charity and holding onto a life estate, the homeowner is entitled to take a current income tax deduction in the year of the gift (subject to certain limitations); and the value of the property will not be taxed in the owner’s estate at death.

For example, assume a 75-year old signs a deed to the home transferring the property to a qualified charity, but retains a life estate.  In this case, the homeowner would be entitled to an income tax deduction for some or all of the value of the remainder interest, and no estate taxes would be due at the owner’s death:

 

Full Value of property $2,000,000

Actuarial value of life estate created for owner, age 75 $800,000

Maximum current income tax deduction $1,200,000

Estate tax on value of home $0

Estate tax saved $1,000,000

The income tax benefit can be substantial and will benefit a charitably inclined donor during life, while the donor can experience the tax savings.

 

The life-estate can extend to the second generation, as well.

For example:

Full value of property $2,000,000

Estate tax at death of second parent to die if no life estate is created $1,000,000

* * * * *

Life estate created for owner, spouse and

2 children ages 80, 75, 57, 55 respectively.

Full value of the property $2,000,000

Estate tax at death of second parents to die if life estate is created $787,500

Maximum current income tax deduction $425,000

Estate tax savings $212,500

Potential total income and estate/gift tax savings $637,500

 

If the life estate extends to a second generation, the parents may be making a taxable gift at the time the life estate is created.  In the above example, if the parents have not made any other significant lifetime gifts, the parents will not have to pay a gift tax because the first $1,000,000 of gifts by each parent will be shielded from the gift tax.

The longer the period of the life estate (e.g., children’s or grandchildren’s lives) the greater the value of the property in the parent’s estate and the greater the estate tax.  Incorporating life insurance in the planning can provide a source of payment of the increased estate taxes resulting from the extended life estate.  Moreover, if insurance is purchased on the lives of the children, it could provide funds to purchase back the property from the charity for the benefit of the grandchildren.  The cycle can begin again.

The issue of management of the property during the period of the life estate should be addressed and a Management Agreement among the family members is recommended.  If the property is of large acreage, a portion could be sold or donated or a combination thereof, and the life estate can be created on the reserved residence portion.

In summary, the use of a life estate is an effective tool to significantly extend the period the family can enjoy the use of a personal residence or farm while at the same time fulfilling a charitable interest.