What Is an “Implied Life Estate” and Why Should Heirs Know?

Our readers will recall that creating a life estate is a way to divide property ownership, with a resident keeping a home throughout their lifetime and then passing a “remainder interest” on to someone else upon death. When the person who lives in the home passes away, the owner of the remainder interest may have the benefit of a stepped-up tax basis, which eases the burden of capital gains taxes.

That tax benefit is one reason a homeowner might create a life estate deed rather than simply giving the home away.

But did you know a life estate can also be “implied” even if the late owner transferred the deed away during their lifetime?

If you’re inheriting property from an estate, or administering an estate, you’ll want to be aware of the implied life estate. If the deceased individual transferred the deed but continued to behave as an owner would, the possibility of an implied life estate can provide significant tax benefits through the step-up in basis.

Did the Late Owner Transfer the Home but Continue Living There?

A life estate can be evidenced by the circumstances of the deed transfer and the way the late owner treated the home.

Say the late owner passed the deed to another person but still lived in the home. At first, you might not think the home is part of the estate. After all, once the late owner transferred the deed, ownership ended and the home no longer belonged to the deceased, right?

But further questions should be asked. If the household shared the assumption that the deceased person would stay in the home for life, and the deceased person continued to live there and behave as an owner would, an implied life estate could be present.

The U.S. Tax Court made a decision that’s held up for five decades on this question. The Tax Court determined that a home can be included in the estate and can be treated as an inheritance for tax purposes if the deceased kept control and responsibility for the property. Did the deceased do these things?

• Kept possession of the home for life, without paying rent to do so.

• Paid the property taxes and insurance premiums.

• Performed the upkeep and repairs or upgrades out of their own funds.

• Managed the home generally, possibly earning income from the home.

In other words, for all practical purposes, did the deceased continue to act like a homeowner, even after transferring homeownership on paper? If so, the IRS may recognize the home as inherited, allowing for a tax advantage.

If the person who was given the home lived in it, though, a life estate will not be recognized. In a life estate, the deed holder gives only a future interest in the home to the recipient, who will not possess and manage the home until the owner who left that future interest dies.  

Should you transfer your deed to your adult child? A tax pro might say no. Giving away a home while still alive can be a financial mistake.

How the Tax Advantage Works

In some cases, the late homeowner would have really wanted to transfer a life estate deed to retain an interest for life and then let the heir step into the home after the owner’s death. But not being aware of this possibility and its tax benefits, homeowners sometimes transfer their entire interest to loved ones ahead of time.

Imagine such a person passes away, and the heirs sell the property to an unrelated buyer. Now, the heirs can expect to receive Form 1099-S (Proceeds from Real Estate Transactions) showing the sale amount.

The heirs will need to report the information shown on Form 1099-S on their individual income tax returns. They will also report the house’s value and tax basis.

Now, say they face a large tax bill for the home’s appreciation. The implied life estate can be useful here. If the late owner stayed in the home and managed the household for life, that’s evidence of a retained lifetime interest in the home. Reclassifying property transferred by a prior gift deed as inherited property can help heirs save considerably on taxes when the former deed holder passes on.

If the home is inherited, it gets a “step-up” to its fair market value at the time of the decedent’s death. Should the heirs decide to sell the home, any rise in value during the deceased person’s lifetime won’t get taxed by the IRS as capital gains.

The heirs should begin their correspondence with the IRS by obtaining an opinion letter from a tax attorney. The letter should include a factual summary of the situation and the lawyer’s opinion that an implied life estate exists and the home should be included in the estate of the deceased.

If the tax attorney believes the IRS will recognize an implied life estate, thus allowing for a stepped-up basis, heirs may decide to notify the estate administrator, submit the opinion letter to the IRS, and follow the tax attorney’s further instructions.

Thinking of transferring an ownership interest in your home? You can find deed forms here.

Is a Lawyer’s Help Necessary?

The federal government has taken an expansive view of what assets should be included in an estate when a person dies. Therefore, finding an implied life estate in the home where the person lived is not unusual. If the facts show a life estate, then it can be recognized—even if the deed doesn’t document it.

That said, each case presents its own set of circumstances. The IRS will treat a residence as an implied life estate on a case-by-case basis.

Finding an implied life estate itself can bring up various factual questions. And it will bring up a number of tax questions, too. For example, how should the beneficiaries of an implied remainder interest report the sale of the home on their income tax returns? If the transfer of the property is instead deemed to be a gift, was Form 709, the federal gift tax return form, filed in the past? Should a late Form 709 gift tax return be filed now? Are estate tax returns necessary? After the resident dies, the state may require an estate tax return. Some states have inheritance taxes on modest estates.

This website does not constitute financial or tax advice. We do hope this article can serve as a kind of checklist or a starting point for your own due diligence. For guidance, contact a lawyer with experience in real estate, taxation, or wills and trusts.