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Understanding the Pros and Cons of a Life Estate

What is a life estate?

life estate is a type of ownership interest in real estate.  Most commonly the life estate is conferred by deed but may also be conferred in a will or trust.  The typical scenario pertains to a parent who wants to “give the house to the kids” for estate and asset protection planning purposes, but retain control over the property. The parent transfers the real estate by deed to the children reserving a life estate for him or herself. The parent is known as the “life tenant,” and the children have what is known as a “remainder interest.”

What are the pros of a life estate?

The life estate avoids probate because the real estate goes directly to the children upon the death of the life tenant.  The life estate can also protect the home from a Medicaid lien upon death, although there is a five year transfer penalty period imposed for nursing home level Medicaid.  The life tenant is entitled to any rental income, continues to pay all expenses of the real estate including real estate taxes, homeowners insurance, repairs, and the capital gains tax exclusion for a personal residence.  The life estate will allow for a full step up in capital gains tax basis upon the death of the life tenant by including the value of the property in the decedent’s taxable estate.

What are the cons of a life estate?

There are some cautions.  A life estate is a legal transfer of the remainder interest to the children.  Thus according to the IRS, it is a gift and you will need to file a gift tax return for the value of the remainder interest if it exceeds the annual federal gift exemption.  Also, if the home is sold during the life of the parent, then the children will receive a proportionate share of the proceeds and may have to pay a capital gains tax. Finally, if the parent later wishes to have the remainder interest returned or needs to borrow on the property, the full and voluntary cooperation of all of the children will be required.

While the life estate is a simple and often used planning tool, and some protections can be built in against the negatives, as always, it is best to consult with an experienced estate planning lawyer to ensure that the life estate is right for you.