Taxation & Estate Planning

Life Estates

By Joel A. Schoenmeyer

People give away their property in lots of different ways. Some people leave specific gifts of money or other property (like real estate), some people just lump everything together (as what's called the "residue") and leave it all to one or more people.

A different way of leaving property involves splitting up the interests of the various beneficiaries. For instance, you can leave a life estate to one beneficiary, with the remainder to another beneficiary. Basically, the idea of a life estate is that the first beneficiary (sometimes called the "life tenant") is given the use of the property for his or her life, and then the remainder beneficiary gets the property upon the life tenant's death.

A life estate is most often used with real estate. For instance, John Smith gives his house to his (second) wife, Mary, for her life; at Mary's death, his house passes to his children from his first marriage, Dirk and Kirk.

You could also do a trust where Mary gets the income from John's property (say, stocks and bonds) during her lifetime, and then Dirk and Kirk get the principal upon Mary's death.

Do you see the problem with leaving a life estate? It creates tension between the different classes of beneficiaries. Some of that tension goes away with a well-drafted document, but not all of it. Speaking of well-drafted, there are a number of considerations with a life estate, including but not limited to:

-who pays for the upkeep of the real estate, Mary or John's trust? -if it's Mary and she doesn't have the money, what happens to the real estate? -are there other scenarios in which the life estate ends (for instance, if Mary sells the real estate or moves into a nursing home or assisted living)? -if Mary is allowed to sell the real estate, will the trust work with her to purchase a new home with the proceeds of sale, and will that new home pass to Dirk and Kirk upon Mary's death?

Similar issues of fairness between beneficiaries relate to a life estate if stocks and bonds are involved. The trustee is placed in a bind -- does she invest in low-growth, income-producing property (bonds, stocks that pay dividends), which would benefit the first beneficiary, or in property that will grow in value (for the remainder beneficiary) but may not produce income? The problem of income beneficiaries vs. remainder beneficiaries became such a big one that many trusts now eliminate the whole "income and principal" distinction. Instead, they give the first beneficiary a certain percentage of the assets in the trust each year. For instance, maybe Mary gets 4% of the value of the trust each year. This creates a situation where all beneficiaries have the same interest (in maximizing the value of the trust).

Full post as published by Death and Taxes Blog on October 05, 2010 (boomark / email).