Thursday December 7, 2023
Case of the Week
Living on the Edge, Part 6
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 Reg. 1.170A-12(d). Lastly, the useful life "clock" starts ticking at the time of a gift and not when the property was built.
Option #4: At the option of an individual, the estimated useful life can be an asset depreciation period that is within the permissible asset depreciation range for the relevant asset guideline class. See Reg. 1.170A-12(d). In other words, an individual can borrow a depreciation useful life recovery period and use it for purposes of determining the building's estimated useful life. For example, the depreciation recovery period for residential rental property is 27.5 years. Thus, when computing the charitable deduction for a gift of a remainder interest in a personal residence, Rhea could simply use 27.5 years for the building's estimated useful life.
The option to select a depreciation recovery period for residential rental property when determining the useful life of residential non-rental property is very favorable for the government. In exchange, this option creates, in essence, a "safe harbor" for individuals. In short, this option is very safe, but may cause an individual to claim a charitable income tax deduction that is less than what they may be entitled to claim.
First, it assumes that it will be used as rental property, which lends an unfavorable characteristic upon the individual's building. Most will agree that rental property, in general, suffers more wear and tear than non-rental property. Yet, in most cases, an individual will remain in the personal residence until death or other disposition. Furthermore, the tax regulations specifically state that the estimated useful life shall take into account the "expected use" of the property. See Reg. 1.170A-12(d). By using the depreciation recovery period of residential rental property, an individual is losing the added benefit of the "actual use" of the property. Thus, an individual is settling for a shorter useful life determination than provided by the tax regulations or life experiences.
Second and most importantly, this option results in a smaller charitable deduction. For example, depending greatly on the land and building value in each situation, the charitable deduction may shrink by 2% to 5% in comparison to a 45-year useful life. If the overall property value is $100,000, the charitable deduction may decrease by a modest amount of $2,000 to $5,000. However, if the overall property value is $1,000,000, the charitable deduction may decrease by $20,000 to $50,000. Therefore, an individual may potentially lose significant tax savings if the 27.5-year useful life is selected.
Yet, as stated above, the "safe harbor" 27.5-year useful life selection is a very safe and conservative choice. If the size of the charitable deduction is less important or the charitable deduction is unable to be utilized, the 27.5-year useful life selection is an excellent option. With four different options to choose from, Rhea visits her attorney again to discuss the best option for her situation.
Editor's Note: There are four primary options for determining estimated useful life. This case study addresses the fourth option. Options one through three appeared in Parts 4 and 5 of this series.
Published November 10, 2023