If children inherit a $300,000 house, their tax basis is $300,000. But what if the parents retain a life e

Question

What are the federal tax implications if parents sell their house to their children at fair
market value, taking back a life estate which ,of course, lasts until the last parent dies?
What is the tax basis of the children in the home? It obviously includes the fair market
purchase price. But how is the life estate handled? It is obvious that a purchase in fee
simple should be worth more than a home encumbered by two life estates of the parents.
So should fair market value at time of purchase be valued by taking into account the life
expectancy of the parents discounted by a reasonable interest rate?
If this is done you might have a situation where the regular fair market purchase value
might be $300,000 if there is no life remanderman . Assume the value of the
remanderman is $100,000. Therefore the adjusted fair market value would be only
$200,000. What is the tax basis for the children when the last parent dies? It obviously
includes the purchase price of $ 200,000. But what about the $100,000 (life estate)
remainderman encumbrance which disappears at death when the children acquire full
title. If the parents lived 2/3 of there joint expected remaining lives -- (say they lived
out 12 of the expected 18 years). Can one argue that the children tax basis is $200,000
plus $33,000 by using the fair market value remaining at time of death?
If the children did not buy the house but inherited it, their basis would be $300,000.
But if they bought it for $200,000 most people would say that their basis is $200,000.
However, that would ignore the value of the remanderman which obviously had a value
which had a life of its own. A life estate or remanderman means that the parents can
live in the home for the rest of their lives without paying rent.

Answer 1

I edit my previous response because I asked my tax professor about this situation, and he said that the retention of the life estate on the part of the parents would indeed affect the basis price in the house -- but he said the matter was complicated and not something that we would cover this year in Federal Income Tax (I suppose it may come up again in Estate Planning: Practice). So my original answer is pretty wrong.

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Original answer follows:

The tax basis for the children would be the $300k that they paid as fair market value for the house. You could view the life estate as something granted to the parents, but I don't believe it would have a tax impact on the parents or the children. I think if you look at it from a policy perspective, if we were to have to consider the value of the life estate to the parents, we would have to consider an intangible item of indeterminate value, and it would be a tax nightmare to try to tax the parents on the value of the life estate, and to balance the value of the life estate against the basis for the purchasing children.

It seems in the problem, though, that the better solution would be to have the parents retain the house and then grant it to the children in their estate, as the children would get the "free" step-up in basis on death -- and then thereby the children would receive the property with the FMV as the current basis, regardless of the parent's basis.

We covered this stuff earlier in this semester in Federal Tax, and I don't recall there being any special situation where the value of the life estate had to be considered in the tax situation when computing basis.

Answer 2

"in the event that they present me the abode or flow me directly to the abode will I be taxed in this in spite of if I stay there" No, present Taxes are paid via the Giver, no longer the Recipient. there is an annual reporting exclusion ($13K for 2012, $14K for 2013) the place the giver does no longer ought to report a latest Tax return. there is likewise an entire life exclusion of $5 Million so they does no longer ought to pay tax. yet, as a latest, you inherit their foundation, so once you bypass to sell it, you are able to ought to pay a earnings on the sale. in case you inherit it, you get the "stepped up" foundation. it particularly is, the cost at time of dying. seek for advice from a qualified tax professional (one that oftentimes deals in belongings and present Taxes) and/or an belongings Planner (no longer purely an annuity/insurance revenues guy) to be sure the terrific direction of action.