Tax planning with life estates

A life estate can be an effective estate planning tool for individuals who want to transfer property to an heir while still keeping the right to use and benefit from that property during their lifetime. It creates a clear plan for who will eventually own the property and can reduce legal complexity after death. However, life estates also come with important tradeoffs, including reduced flexibility and potential conflict between the parties involved. Understanding how a life estate works and the benefits and drawbacks can help you determine whether it fits long-term planning goals.

What is a life estate?

A life estate is a legal arrangement in which an individual, known as the life tenant, is granted the right to use, occupy and benefit from a property for the duration of their life. After the life tenant dies, the property automatically transfers to another person or entity, known as the remainderman, who then receives full ownership. The length of a life estate is limited to the life of the person holding it or, in some cases, another specified individual.

In simple terms, a life estate allows one party to live in or benefit from a property for life while naming another party to receive the property later. It is recognized in both property law and tax rules. According to state and federal sources, a life estate is “an estate whose duration is limited to the life of the party holding it or of some other person.”

How does a life estate work?

When a life estate is created, the property is divided into two distinct interests:

Life estate interest

The life tenant has the right to use and derive income from the property during their lifetime, but remains responsible for maintaining the property, paying taxes and keeping insurance. In addition, the life tenant cannot sell or mortgage the property unless the remainderman (beneficiary) agrees to the sale. 

Remainder interest

The remainderman, like a beneficiary, holds a future interest in the property. The remainderman has no right to use the property during the life tenant’s lifetime but automatically becomes the full owner when the life tenant dies.

For example, a parent may transfer a home to a child but retain a life estate. The parent can continue living in the home for life. When the parent dies, the child becomes the full owner without the need for probate.

However, transfers may not always be so simple. The remainderman, the other beneficiaries of the life estate, may need to determine what their value in the estate is if the property is sold or at time of transfer. The IRS provides actuarial tables and charts to compute the remaindermen's property values, which may also need to be calculated if the property is sold before the life tenant passes or if a present value needs to be determined.

Advantages of using a life estate

Life estates can offer meaningful benefits, especially for individuals who want to plan ahead while keeping the right to use their property.

• Avoidance of probate. One of the primary benefits of a life estate is that formal probate does not apply to property subject to a life estate. The property passes directly to the remainderman upon the life tenant’s death, which helps avoid the delay and expense of probate. Depending on local law, it may still be necessary to complete some paperwork after death, but the process is generally simpler and less expensive than probate.
• Simple and inexpensive to establish. A life estate is simple and inexpensive to create. It is important to consult a lawyer to ensure the transfer complies with state law and to draft the deed properly, but those costs are typically minimal.
• Retention of use and benefit. A life estate allows the life tenant to keep the right to live in and use the property for life. This is helpful for individuals who want to transfer property to heirs while continuing to reside in the home or benefit from it during their lifetime.
• Potential tax benefits through basis adjustment. Normally, when gifting property during life, the basis of the property in the hands of the donee is the same as the basis of the property in the hands of the donor immediately before the transfer. However, when the transferor retains a life estate, §2036 causes the entire property, including both the life and remainder interests, to be included in the transferor’s gross estate. As a result, §1014 requires adjusting the basis of the property to its fair market value at the time of death. This basis adjustment can reduce capital gains tax for the remainderman if the property is later sold.
• Medicaid planning. In some states, creating a life estate may help with Medicaid eligibility if the transfer is made outside the look-back period, but the property may still be subject to Medicaid estate recovery after the life tenant’s death. Consult a qualified elder law attorney for state-specific guidance.
• Support for blended families and a surviving spouse. A life estate may be used to provide for a surviving spouse when blended families are involved. This can help balance family goals by allowing the spouse to continue living in the home for life while ensuring the property ultimately transfers to the intended remainderman.
• Clarity of succession. A life estate clearly defines who will inherit the property, which can reduce confusion and lower the risk of disputes among heirs.

Disadvantages of life estates

While life estates can be useful, they also come with limits that can complicate later decisions. Many disadvantages involve reduced flexibility, shared ownership interests and potential tax consequences.

• Loss of full control and difficulty selling. Once a life estate is created, the life tenant cannot sell, mortgage or otherwise dispose of the property without the consent of the remainderman. To sell the property, all owners must agree and sign the deed, including life tenants and remainder interest owners. This loss of sole control can create complications if circumstances change. If the life tenant is mentally disabled, a guardian may need to be appointed to exercise the life tenant’s rights and determine whether a sale is in the life tenant’s best interest.
• Potential for unforeseen income tax consequences on sale. If the owners sell the property before the life tenant’s death, there is potential for unforeseen income tax consequences. Life tenants generally receive the §121 capital gain exclusion normally available when a taxpayer sells a principal residence, but only for the portion of gain allocated to the life interest. Remainder interest owners receive no such exemption unless they lived in and owned the property for two of the last five years before the sale. As a result, capital gains tax would likely be due from the remainder interest owner’s proportionate share of the proceeds.
• Limited control for remaindermen and enforcement issues. Remaindermen have no ability to deal with the property until the life tenant’s death. The life tenant has a legal duty to preserve the property and must not, through action or inaction, abuse or destructive use, reduce its value. However, it can be difficult for remaindermen to enforce that duty, especially in a parent-child relationship.
• Potential for conflict. Disagreements may arise between the life tenant and the remainderman regarding property maintenance, improvements or use. Both parties have vested interests, but their priorities may differ.
• Irrevocability. Life estates are generally irrevocable. Once established, the arrangement cannot be undone without the agreement of both the life tenant and the remainderman. This can be problematic if family or financial circumstances change.
• Property tax and homestead issues. A county property assessor may require owners to reapply for a homestead exemption after the transfer. A local tax assessor may also use the transfer as an opportunity to increase an assessment up to fair market value. Because a life estate is generally irrevocable, make inquiries before completing the transfer.
• Medicaid look-back and disqualification period. The Medicaid 60-month waiting period means a life tenant may face a 60-month disqualification period for Medicaid purposes if the transfer occurs within the look-back window. In addition, the property may still be subject to estate recovery or clawback by Medicaid after the life tenant’s death in some states. Consult with a Medicaid attorney to review all possible consequences of an ineligible sale or transfer.
• Responsibility for expenses. The life tenant is typically responsible for property taxes, insurance and maintenance. Failure to meet these obligations can negatively affect the remainderman’s interest.
• Gift and estate tax considerations. The creation of a life estate may be considered a completed gift for federal gift tax purposes depending on the retained powers and rights. If the life tenant retains significant control or creditors can reach the property, the gift may be incomplete and the property may still be included in the life tenant’s estate for estate tax purposes.
• Valuation of life estates. For tax and legal purposes, the value of a life estate and the remainder interest is determined using actuarial tables and the applicable federal rate under §7520 of the Internal Revenue Code. The age of the life tenant and prevailing interest rates are key factors in this valuation.

Planning considerations

A life estate is a powerful estate planning tool that allows individuals to transfer property to heirs while retaining the right to use and benefit from it during their lifetime. It offers advantages such as probate avoidance and the potential tax benefits of basis adjustment. However, life estates have notable disadvantages to consider, including Medicaid look-back risks and potential income tax consequences upon sale. Professional guidance is essential to ensure a life estate fits your estate planning goals and personal circumstances.

Take the next step with NATP education

Life estates often come up in planning discussions involving older clients and their families, especially when property transfers and tax consequences intersect. To build your knowledge and serve senior clients with confidence, take NATP’s online education course, Tax Issues for Seniors. It covers key tax topics affecting older taxpayers and helps you spot planning opportunities and compliance issues before they become problems.