Dear Michael: About ten years ago, after my husband died, in his will he put our land into a life estate with our children. At the time, none of the children wanted to farm. Since then one of our son has come back home and decided to take a lot of the land that was in CRP for many years and has turned it into farmland. Land that was barely worth five hundred dollars is now – as of the last sale next to us – is now selling close to five thousand dollars per acre. We put over twelve hundred acres into life estate to keep it from going to the nursing home. Did we do the right thing? – 20/40 Hindsight?
Dear 20/40 Hindsight: This has come up a number of times in the past few years and mostly because of land values jumping in value. It's especially critical when you took non-productive land and, with new farm methods, turned it into productive land. This certainly changed the value of the land in a farmland starved environment as we have now.
IRS has a whole code written about life estates. First of all, they have a table to determine what the value of the two parts of a life estate are – the 'life estate' or right to receive income or use for the remainder of life and the 'remainder interest' deed – which is the deed given to the children. They receive it upon the end of your right to receive income – at your death. Based on your age at the time your husband 'gifted' the remainder deed to your children via his will, the land should have been appraised at the time, and a gift tax return filed for the value of the remainder deed based on the IRS table.
This IRS table is based on age. The younger you are at the time of the gift, the less you are giving to your children due to, actuarially speaking, you'll likely live for a long time before your children finally receive the land without any income to you. For example, If you are age one, the gift to your children is virtually nothing – if you could have children at that age. By the time you reach ninety, the table tells us the gift your making is almost the entire fair market value of the gift.
A mid-point is right at age seventy-six when IRS says the value of the life estate interest is roughly equal to half the fair market value of the property at the time of the gift. So, if you are age seventy-six and gave land valued at one million dollars, you would need to file a gift tax return for half a million dollars.
The good news is you can give up to five million three hundred and forty thousand dollars per person in 2014, so there would be no gift taxes upon this gift – but it does reduce this total Unified Credit by this amount.
The problem comes later on when this same IRS tax code states that if you keep a life estate interest in this property, the property will be included in your estate for estate tax purposes at its full market value at the time of your death. In other words, you lose some of your lifetime credit when you make the gift of the residual deed to your children but you still have to pay estate taxes based on what's left of your credit and the total value at the time of your death.
For people who've done this over the past decade, make certain your land is not valued for more than five million three hundred forty thousand now, or you are guaranteed your children will pay estate taxes when you die.
In your case, if land is selling for five thousand an acre and you have twelve hundred plus acres in life estate, that adds up to about six million dollars. Anything over the five million three hundred forty thousand dollars – in your case about seven hundred thousand – is going to have forty percent estate taxes upon it. Bad as that may be, that's just the value today! What happens if you live for another twenty or more years and the land continues to appreciate over time. Every dollar it goes up in value is another forty percent to the IRS.
What you can do is start shifting out of your life estate – either by gifting your life estate interest to your children today – or setting up a special trust to hold your life estate interest until you die. Doing either is going to affect their step-up basis, but that only affects your children if they sell the property. Good estate tax planning is about avoiding certain taxation at the time of death versus long-term taxes on capital gains.
The other thing that happened – beyond your control – was that now that your son came back to the farm and wants to farm, how is he going to handle being partners with his siblings for the rest of his life? That's a whole 'nother can of worms that needs to be worked out – usually with patient negotiations between the children before you die. They'll still listen to you now, but don't count on it after when millions of dollars are at stake.