Wednesday April 24, 2024

6.5.1 Life Estate Reserved

Life Estate Reserved

Charitable Income Tax Deduction:  To illustrate how the deduction is calculated, consider Jane Donor who gifts her home on June 1, 2017 to her favorite charity, but reserves a life estate, or the right to live in the house for her lifetime.

Gift Tax Deduction:  The transfer of a remainder interest in property to charity also provides the donor with a charitable gift tax deduction.

Estate Tax Deduction:  An individual who retains a life estate may receive a charitable estate tax deduction at death.
An individual may gift a property, such as a personal residence or farm, to a qualified exempt charity and retain the right to live on or use the property for life. Giving property to a charity and retaining a life estate provides a donor with several tax benefits. The donor receives a charitable income tax deduction for the present value of the remainder interest given to charity. The deduction is calculated using the applicable federal rate (AFR) under Sec. 7520 and factors from IRS Pub. 1457. It is important to note that the remainder interest is reduced using straight-line depreciation. Sec. 170(f)(4).

To determine the amount of straight-line depreciation that must be taken, the useful life and salvage value of the property are necessary. The depreciation calculation for personal residences also entails a division of the land and building values. To minimize the total depreciation, it is preferable to assume a long useful life and a reasonably high salvage value. An appraiser may have difficulty determining the useful life and salvage value with precision, but Reg. 1.170A-12(b)(3) provides estimates of useful life and salvage value. For example, the Treasury lists a standard 45-year useful life and a standard salvage value of 20% of the current value. These estimates may be used unless an appraiser specifically recommends different estimates.

Charitable Income Tax Deduction
While Crescendo incorporates information from IRS Pub. 1457 in its software, it is helpful for gift planners to know how the deduction calculation would be performed if they had to look up all factors. To illustrate this, consider Jane Donor who gifts her home on June 1, 2017 to her favorite charity, but reserves a life estate, or the right to live in the house for her lifetime. Jane is 68 years old. The fair market value of her home is $100,000. The appraisal of Jane's home shows a building value of $30,000 and a land value of $70,000. The appraiser used the standard useful life of 45 years and the standard salvage value of 20% of the current building value ($6,000). The AFR for the month of June is 2.4%. Using this information and IRS Pub. 1457, the charity's gift planner creates the following charitable deduction worksheet.

Life Reserved
One Life
  Donor:   Jane Donor   Birth Date:   06/01/1949   Age*:   68
  Gift Amount:   $100,000   Gift Date:   06/01/2017   Land:   $70,000
  Building Value:   $30,000   Useful Life:   45   Salvage:   $6,000
        * Age calculated to nearest six months

  (A) Factor:         Age    68 0.70312 (A) 
         AFR of the Month:   2.4%    
         (IRS Pub. 1457, Table S)    
  (B) Deduction Value of: Land + Salvage $53,437 (B) 
         (Land + Salvage) x Line (A)    
         (Reg. 1.170A-12(b))    
  (C) Remainder Interest Factor for
         Depreciable Property (Buildings)		 0.48310 (C) 
         (Reg. 1.170A-12(b))    
  (D) Deduction Value of: Bldg. - Salvage $11,594 (D) 
         (Bldg. - Salvage) x Line (C)    
         (See Also IRS Pub. 1459)    
  (E) Total Value of Remainder Interest $65,032 (E) 
         Line (B) Plus Line (D)    
 

With 3% appreciation for 22.9 years, future value after $9,839 sale costs is $186,937. Present value at 3.00% is $95,000.


The charitable deduction worksheet contains valuable information about the donor. Jane's name, birth date and age, the gift amount, gift date, land value, building value, useful life and salvage value are all listed and used to compute Jane's charitable tax deduction.

The second box contains the factors used to determine the amount of the charitable deduction and shows the steps taken to determine the charitable tax deduction for Jane's gift. The steps are explained in paragraphs (A) through (E) below.

(A) The remainder percentage for a single life is found in Pub. 1457, Table S. The AFR for the current month or either of the two prior months may be used to determine the charitable deduction under Sec. 7520. For a life estate reserved, the lowest AFR produces the greatest deduction, so Jane's gift planner selects June's 2.4% AFR. Locate the table corresponding to the 2.4% AFR selected. Find Jane's age (68) in the left column of the appropriate chart and travel across the row to the remainder column. The corresponding number is the remainder percentage (0.70312).

(B) Reg. 1.170A-12 specifies the method for determining the deduction value of the land and salvage values. First add the land ($70,000) and salvage ($6,000) values together. Next, multiply the sum ($76,000) by the 0.70312 remainder percentage shown in Line (A). The result is a deduction value of $53,437.

(C) The remainder interest factor for depreciable property is computed using the formula listed in Reg. 1.170A-12(b)(2). The formula is complex and based on several independent factors such as the estimated number of years of the useful life, the AFR, the age of the life tenant and Table 90CM. The program will perform the calculation. Here, the remainder interest factor is 0.48310.

(D) To determine the deduction value of the building minus the salvage value, subtract the salvage value from the building value and multiply the result by the remainder interest factor shown in Line (C). Here, the salvage value of $6,000 is subtracted from the building value of $30,000 and the resulting $24,000 is multiplied by 0.48310 to produce $11,594.

(E) The remainder interest, or the present value of the gift to charity, is calculated by adding the deduction value of the land and salvage (Line (B)) to the deduction value of the building minus the salvage value (Line (D)). In other words, $53,437 plus $11,594 equals $65,032. Jane will receive a charitable tax deduction of $65,032 in the year of the gift.

Gift Tax Deduction
The transfer of a remainder interest in property to charity also provides the donor with a charitable gift tax deduction. When a donor makes a gift in excess of the annual exclusion amount, the donor must pay tax on the excess. However, gifts made to charitable organizations in excess of the annual exclusion are offset by a 100% charitable gift tax deduction. Sec. 2055(a). Thus, the donor will pay zero gift tax on donations made to charity.

Estate Tax Deduction
An individual who retains a life estate may receive a charitable estate tax deduction at death. Sec. 2055(e)(2). If the agreement provides for a two-life estate and the donor retains a testamentary power of revocation, the donor's estate may suffer tax liability for the second person's life estate. If the donor transfers a life estate to a surviving spouse, the donor's estate qualifies for a marital deduction. Sec. 2056(b)(7). However, if a life estate is transferred to a child, nephew, niece or other person, the donor's estate may be taxed on the value of such interest. In addition, when a donor retains a revocation power, the full value of the property is artificially included in donor's estate at death. Sec. 2036(a).

Filing Form 706 provides donor's estate with a charitable estate tax deduction. Like the charitable gift tax determination, depreciation is not used for charitable estate tax calculations. Rev. Rul. 76-473. In the Crescendo program, all value should be allocated to the land value. This omits depreciation in the estate tax calculation. Donor's estate must file Form 706 reflecting the property's full value as of donor's date of death. The total value of the property less the present value of the life estate of the non-spouse beneficiary is the taxable portion.

Related Topics on Life Estate Reserved

1.3.1  Estate Tax Overview:    An estate tax may be levied on the transfer of property when a person passes away. However, an estate distributed to a surviving spouse who is a U.S. citizen is not taxable. Sec. 2001(a). There is also an estate tax exemption, which excludes most estates from this tax.

1.3.2  Estate Applicable Exclusion Amount:    The Estate Tax Rate and Estate Exclusion schedule under EGTRRA 2001 are given.

1.3.3  Charitable Estate Deductions:    A full charitable deduction is permitted for a bequest of cash or property to a charity. Sec. 2055(a). The transfer to charity may be through a specific bequest of a particular asset or a percentage of the whole estate or of the residue. It is essential that the designation be made to a qualified exempt charity.

1.3.4  Marital Deduction:    Since 1981, there has been an unlimited marital deduction. Individuals who are married may transfer any assets outright to a surviving spouse, with the entire transfer qualifying for a marital deduction. Since it is desirable to preserve the value of the applicable exclusion amount for the first spouse to pass away in a bypass or family trust, a common plan is to fund a bypass trust to the maximum amount and transfer the balance of the estate outright or in trust to the surviving spouse.
1.3.5  Disclaimers:    A beneficiary of an estate may disclaim property. If the disclaimer is valid, the assets will pass to a contingent beneficiary or to the residue of the estate.

1.3.6  Estate Tax Calculation and Form 706:    The calculation of estate tax is a cumulative process. That is, all prior gifts and prior taxes payable under current schedules are considered when calculating the current estate tax liability.

1.3.7  Zero Estate Tax Planning:    There are three major potentially favorable areas for philanthropy in The Economic Growth and Tax Reconciliation Relief Act of 2001 (EGTRRA 2001): the inclusion of estate tax reform, the increased opportunity for zero estate tax plans, and the ability to increase transfers to family for those persons with large IRAs or pension plans.

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