Income Tax Issues With the Sale of Life Estates

A "remainderman" will take full ownership of a house after the life tenant dies.
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A life estate divides ownership in a home in an unusual way. One person, the life tenant, has the right to live in the home for life. The other person, the "remainderman," receives full ownership after the tenant dies. For example, if your father makes you his remainderman but reserves a life estate for himself, you can't throw him out if you quarrel. Likewise, your father could also leave you his house in his will, leaving a life estate to your stepmother, so she doesn't become homeless. If the house must be sold, it can have tax consequences for the life tenant and remainderman, and everyone with an interest in the property must agree to the sale.

Exemption Rules

The IRS cuts homeowners a lot of slack if they sell their personal residence: if you own your home outright and have lived in it for at least two out of the five years before you sell, you can exempt up to $250,000 in gain -- compared to the purchase price -- from capital gains tax, as of 2012.

Life estates are different. If a home is encumbered with a life estate, both the remainderman and the life tenant must report their share of the capital gains on their tax returns. Depending on circumstances, the tenant can still often exempt some or all of his share, because it's his personal residence, but the remainderman typically cannot. This can result in a sizable tax bill for the remainderman.

Dividing the Gains

When you sell a home with a life estate, the IRS divides up the capital gains based on a formula involving the age of the tenant -- based on his life expectancy, in other words. If the gain on the house is $120,000 and the formula shows the remainderman and the life tenant currently have a 50-50 interest in the home, you each have $60,000 in capital gains to report. If your state government taxes capital gains, the exemptions and rates will be different, but you will have to report this as well.

Waiting It Out

If you become a remainderman but don't sell until after the life tenant dies, technically, there is no more "life estate" -- you simply own the house outright -- but the tax situation might work out better for you. Suppose your father bought the house for $100,000, the life tenant is still alive and the home is worth $750,000 when you want to sell: If you sell it now, the "basis" for measuring the gain on the sale is $100,000: there will be about $650,000 in capital gains to report when you sell, divided between you. If you sell after the tenant dies and the home is worth $750,000 when he dies, the basis increases to $750,000. If you sell for $750,000, there is no capital gain to report on your income tax return.

Selling Just the Life Estate

A life tenant can sell a life estate interest to anyone who is willing to buy it. In this case you are selling only your interest in the home -- the right to live there for the rest of your life, and not for the lifetime of the buyer. If you are 80 and sell your life estate interest to your 20-year-old grandson, he will have the right to live there until you die, not until he dies. The income tax situation with regard to selling your life estate interest is similar to the situation if you and the remainderman sold the house together -- if you're selling your personal residence and meet the IRS residency requirements, you can exclude some or all of your capital gains.

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