Thursday December 7, 2023
Case of the Week
Living on the Edge, Part 5
Case:Rhea Jones, 75, lives in a beautiful coastal town in northern California. Rhea's home occupies three magnificent acres of bluff property that overlooks the crashing waves of the Pacific. Since her home sits just steps away from the dramatic cliffs, Rhea frequently jokes to her friends about her "living on the edge" lifestyle.
John, Rhea's husband of 50 years, built the custom home 10 years ago. It was truly the realization of their lifelong dream. Unfortunately, John passed away unexpectedly five years ago. Now, Rhea lives alone in the large home. Nevertheless, Rhea is looking forward to spending her remaining days in this lovely home. Not surprisingly, she frequently plays host to her children, grandchildren and friends.
Rhea is an active philanthropist. In fact, she spends three days a week volunteering with local charities. While very wealthy and philanthropic, Rhea makes only modest yearly gifts. However, she intends to make a substantial bequest upon her death. Specifically, Rhea plans on distributing her entire estate to her children and grandchildren, except for her cliffside home. Rhea's estate plan provides that the home passes to John and Rhea's favorite charity upon her death. The home is worth $13 million.
At a recent estate planning presentation, Rhea discovered the benefits of a gift of a remainder interest in a personal residence. In particular, she liked the potential significant tax savings avoiding the estate administration process. Also, because the gift is irrevocable, the local charity would recognize and honor Rhea for her generous gift at the annual fundraising gala. Of course, Rhea would retain the right to live in her home for the rest of her life, which is an absolute requirement for any potential gift arrangement.
Question:Rhea is very excited about this gift arrangement, but she has many questions for her attorney. Before she commits to the gift plan, she wants to address several questions. Her primary question is how is the charitable deduction set for a gift of a remainder interest in a personal residence?
Solution:When calculating the charitable income tax deduction for a gift of a remainder interest in a personal residence or farm, the overall value of the contributed property must be divided between the land value (non-depreciable portion) and the building value (depreciable portion). There is no simple default rule for this division. After a thorough review, the qualified appraiser calculated the land value at $9 million and the building value at $4 million. This vital information is passed along to Rhea's advisor.
In determining the value of a gift of a remainder interest in a personal residence or farm, depreciation must be taken into account if any part of the contributed property is subject to exhaustion, wear and tear or obsolescence. See Sec. 170A-12(b)(1). The tax code requires the straight-line method of depreciation. In order to compute depreciation, a donor must determine the estimated useful life and salvage value of the building.
"Estimated useful life" is the estimated period of time that an individual's property may reasonably be expected to be useful. In determining this time period, the "expected use" of the property must be taken into account. See Sec. 170A-12(d). Lastly, the useful life "clock" starts ticking at the time of a gift and not at the time the property is built.
Option #3: Individuals may look to the tax regulations for guidance. In particular, the tax regulations provide two good examples of gifts of a remainder interest in a personal residence that illustrate the proper application of the valuation rules. In both examples, the tax regulations use an estimated useful life of 45 years for a personal residence. See Sec. 170A-12(b)(3) and Sec. 170A-12(c). While not definitive, the tax regulation examples are very useful and instructive.
Thus, Rhea's attorney advises that an estimated useful life of 45 years for a personal residence is a reasonable estimate, since the tax regulations apply this 45-year figure in both personal residence examples. In addition, since Treasury has since updated the regulations without changing the personal residence estimated useful life examples, an individual could assert that Treasury continues to view 45 years as a reasonable estimate. Of course, each individual's building and tax situation is unique. Therefore, individuals should consult qualified counsel before using this option.
Rhea likes the simplicity, time savings and cost efficiency of option #3. Moreover, she knows that a useful life of 45 years will provide her with very good tax benefits. Before making her final decision, however, Rhea wants to understand option #4. The fourth option will appear in Part 6 of this series.
Editor's Note: Crescendo's life estate reserved software proposal program uses 45 years as the default estimated useful life. This default setting is designed to give individuals a reasonable and safe useful life estimate, since many individuals do not know the estimated useful life of the building in question. Crescendo is unaware of any IRS challenge against a legitimate gift of a remainder interest in a personal residence where the estimated useful life used was 45 years.
Published November 3, 2023