Why Not A Life Estate?

Robert asks why a life estate on a house is a bad idea and what effect it has on gift taxes.

QUESTION: Robert in Ohio from My Total Money Makeover asks why a life estate on a house is a bad idea and what effect it has on gift taxes. Dave says there isn’t an estate tax this year, and that makes things a little more complicated depending on what happens with the law.

ANSWER: Here’s the problem: Everything is up in the air on estate tax planning until the evil Bush tax credits are addressed. We don’t know what’s going to happen with estate tax planning right now. Technically, at this moment, there’s not an estate tax. This is a good year to die because it’s the only year in decades that there’s not been an inheritance tax. There will be another inheritance tax, I suspect, starting next year.

All of that aside, the way things normally have worked depending on what they do with the law, when you inherit an item after someone dies, your basis for tax purposes is the value of the item, so you only pay taxes on what it goes up in value after you become the owner of it. If Mom dies with a $300,000 house and leaves it to you and it’s paid for, you sell it for $300,000, you have zero taxes. If you own the house because she gave it to you prior to her death, then you will pay taxes on anything over what she paid for it. If she paid $50,000 for the $300,000 house, you’re going to pay capital gains on a $250,000 gain because you were gifted the house prior to death. That’s called a stepped-up basis. That’s why we recommend you receive these things—depending on the size of the estate—at death, not prior to death. If she gives you this house prior to death, she’s very likely going to have gift tax on the value of the house, which could be huge.

The life estate portion just allows her to live there until she dies. That isn’t the problem. There’s nothing wrong with a life estate. The problem is that you took the house and missed out on all the tax benefits of receiving it after death the way current tax law is written.