Have you often heard the term ‘life estate’ and thought how does one work? A life estate is a legal arrangement to transfer assets, typically house and/or land, that you want to keep in the family. Generally, the transfer is from parents to a child or children, with the parents retaining the rights to live in the home and/or receive income rights, such as land rent, until death at which time the right passes automatically to the children.
There are three categories of owners:
- Current Owner (Grantor) – the person creating the deed
- New Owner (Life Tenant) – the person(s) who own the life estate
- Future Owner (Remainderman) – the person(s) who will acquire the property when the life tenant dies
Often, the same party may serve in multiple roles - the grantor is usually the life tenant. Also, multiple individuals may serve in the same role – i.e. two grantors, three joint life tenants, and one remainder beneficiary.
There are a couple types of life estates:
- Granted Life Estate, which is usually performed within the will, is when the first spouse passes, the other spouse will become life tenant with children becoming the remainderman. This typical life estate is used to avoid probate
- Retained Life Estate, is when a life estate is created while the grantor is still alive. The grantor executes a deed transferring property to the life estate, then upon death, the deed will be transferred and owned by the remainderman. This type of life estate is typically used in place of a revocable trust and to avoid probate
To create a life estate deed, one would typically contact an attorney to write up the written document. Then you would execute the new deed for the property with the county to transfer the property from yourself to the life estate. This may also be created in a will or a trust. Most often, an appraisal is recommended to establish fair market value for calculating your value of property for the gift tax return.
Now you may ask, what assets could I put into a life estate? The most common assets would be real estate that you want to keep in the family - such as a house or land. Other assets could be certificates of deposit, bonds, and Real Estate Investment Trusts (REITS). Typically, depreciable assets are not advised to be put in life estate.
Advantages of a life estate:
- They are usually more affordable and less time consuming than other options
- They are not included in the probate estate but will be in the taxable estate (although the current federal estate exemption is $11.58 million in 2020 for an individual, which is scheduled to sunset at the end of 2025)
- The life tenant is able maintain control and use while alive
- Provides fair opportunity for the life tenant and the remainderman as it cannot be sold unless both parties are in agreement and the sale proceeds are divided amongst each other
- The remainderman receives a stepped-up basis upon life tenant’s death
- Will not be included to recompense Medicaid costs depending on the state
Disadvantages of a Life Estate:
- Irrevocability - While not strictly impossible, it is extremely difficult to change things
- If sold prior to the life tenant’s death, both parties have to agree in order to sell and the remainderman will receive a percentage of the proceeds, which could create some large capital gains as the cost basis must be used
- Real estate is not protected from litigation, divorce or bankruptcy
- If the life tenant moves into an extended care facility within five years after the life estate deed is created, Medicaid can require the sale of the asset
- If the remainderman were to pass away before the life tenant, the assets may have to pass through probate of the remainder owner’s assets and will
- A gift tax return will need to be filed, which will reduce the lifetime exemption
When it comes to the treatment of life estates by state, North Dakota and Wisconsin are very similar as the remainder interest is protected after five years and the life interest is not counted towards the available assets - although income from the asset would be included in North Dakota. As far as for Minnesota, a single person is alike North Dakota and Wisconsin. Although married couples are different. A Minnesota Supreme Court case ruling passed in June of 2020 that further restricted what can be protected with a life estate. In this case, the husband’s portion of the life estate was included in the asset valuation when the wife was going into elder care.
As you can see, it is important to note life estates are not for everyone and the circumstances and requirements for each of these take some careful consideration. However, the time and costs to learn are minimal and the benefits may be great and long-lasting. If you may be interested or have any further questions, feel free to contact the succession & retirement team or your local AgCountry tax specialist.