A life estate is a legal arrangement to transfer property automatically upon a person’s death. One person is given an interest in the property for his or her lifetime. This person is called a life tenant (LT). At the death of the life tenant, property will pass automatically to one or more other individuals or organizations. The people or organizations that receive the property at death are called remaindermen. Life estates are sometimes used as a tool to avoid probate (but see below).
It is important to understand that a life estate is a form of co-ownership. Both the LT and the remaindermen have real interests in the property. But unlike other forms of co-ownership, the co-owners do not have rights to the property at the same time. Instead, their interests are stacked in time, with only the LT having a right to current possession of the property. The remainderman’s interest does not kick in until the death of the LT.
Pitfalls of Using Life Estates to Avoid Probate
Most people use life estates because they want to avoid probate. There is a better way, which I will discuss below (hint: it involves a living trust coupled with a deed to the living trust). But before we get there, let me tell you why I don’t usually recommend life estates as a primary probate avoidance tool:
- Impaired Ability to Deal With the Property. Because life estates give the remaindermen a real interest in the property, the LT cannot deal with the property without involving the remaindermen. What if the LT needs to sell the property but the remaindermen refuse? The LT could be trapped in a situation that is not in his or her best interest. This is probably the most important reason for caution in the use of life estates.
- Conflicts Between Remaindermen and Life Tenants. State law typically allocates the expenses associated with the property between the life tenant and the remaindermen. The LT is responsible for the interest portion of the mortgage, property taxes, insurance, and ordinary upkeep and repairs. The remaindermen are responsible for the principal portion of mortgage payments and extraordinary repairs. Often the LT cannot afford (or simply doesn’t pay) the expenses associated with the life estate. Or the remaindermen do not pay their share of the mortgage or extraordinary repairs. Or there is a dispute as to whether a repair is ordinary (the responsibility of the LT) or extraordinary (the responsibility of the remaindermen). This creates the potential for ongoing conflict.
- No-Win Situation for Life Tenant. Because the LT has only a lifetime interest in the property, he or she has a duty to the remaindermen to maintain the property. But what if the LT cannot afford to do so? As we saw above, a sale is only possible if all parties agree. If they cannot, the LT may be trapped in no-win situation where she cannot afford to meet her duty to the remaindermen.
- Valuation Issues. Suppose that the property needs to be sold and the life tenant and remaindermen can agree on a sale price. Who gets what? The life tenant may think that the life estate is valuable and that he or she should get most of the sale proceeds. The remaindermen may argue that the life tenant’s interest is worth little (since the life tenant could die any minute) and that the bulk of the sale proceeds should go to them. And even if they work out the allocation of the proceeds, the IRS will typically apply an arbitrary set of actuarial tables for tax purposes that may not match the true economic situation.
- Estate and Gift Tax Issues. Life estates given to a person’s spouse generally qualify for the federal marital deduction. This allows postponement of the estate tax until the death of the surviving spouse, depending on whether the election is made to qualify the property for the marital deduction. If the election has been made but the spouse later sells the home and divides the proceeds with the remaindermen, the spouse may be considered to have made a taxable gift of a portion of the proceeds. The gift tax may also apply if the election is not made but the proceeds are split in some manner other than according to the IRS’s actuarial tables.
- No Escape. Partition is a judicial procedure that allows co-owners who have current possessory rights in property to either divide or sell the property and go their separate ways. But because the interests of the life tenant and the remaindermen are not possessory at the same time, the remedy of partition is not available. This can lock the life tenant and remaindermen into the forced partnership without any judicial means of escape.
Living Trusts: A Better Way to Avoid Probate
All of the benefits of a life estate can be achieved through a living trust without these drawbacks. A living trust is a document that creates a legal entity (the trust) that exists during your lifetime for the purpose of holding title to your assets. Living trusts are popular tools for avoiding probate.
Here’s how a living trust would work as a (better) alternative to a life estate:
- You create a living trust during your lifetime. You retain full control over the trust, including the right to revoke the trust or “undo” any transfers that you make to the trust. The trust provides that your real estate will be transferred automatically upon your death to whoever you want to have it.
- You deed your real estate to the living trust. This takes it out of your name so that it will not be part of your probate estate when you die. You still have full control over the property, though, since you control the living trust. This means that, unlike a life estate, you can still call the shots during your lifetime. And since the trust is disregarded for tax purposes, there are no negative tax consequences.
- When you die, the trust provides for the automatic distribution of the real estate to whoever you want to have it. This occurs outside of the probate process since the property is not in your name, but in the name of the trust.