Dillon Law PC

 

 

 

 

You get what you plan for

 

For many years, a life estate to the surviving spouse with a remainder interest to the children was a cheap effective way to pass real estate without a lot of complex will drafting. Further, it ensured that a second spouse and that spouse’s children didn’t “get their hands on” family assets, usually farm ground. The elder generation essentially got to behave as if the ground was still entirely theirs (rent collected, taxes paid, military and homestead exemptions applied) until their death.

 

Property is like a bundle of sticks. Each aspect of property (right to use, responsibility to pay taxes, mineral rights, wind farm rights) is one of the sticks in the bundle. Under a life estate, one person holds onto the right to occupy and use the property along with the responsibility to pay the taxes (the Life estate holder). Another person(s) (remainderman) hold the rest and when the first person dies, those “sticks” transfer to the second person(s).

 

However, recent litigation and court rulings have weakened many of the arguments in support using a life estate. First, while the transfer occurs upon the life estate holder’s death, the remainderman cannot take those sticks without clearing a Medicaid lien on the property. The value of the life estate holder’s interest is figured just prior to his death. This can mean that despite transfer of substantial interest in the farm prior to death, a life estate holder on title 19 can be made to pay back part of moneys advanced for their care in a long term care facilty.

 

Second, the tax basis for a life estate property is established at the time of transfer, not at death. If it was not a sale with a retained life estate, then the remaindermen get the transferor’s presumably low basis in the property, not the higher “stepped up” basis that they would have received had the property been transferred via probate proceedings.

 

It gets even more tangled and snarled when folks retain a life estate to their spouse, then a life estate to their children and make the grand children the remaindermen. This can run afoul of federal gift tax law because the gift to the grandchildren is a gift of a future interest, and no gift tax exclusion is available for such a gift.

 

The life estate may still have some applicability, but its use as a quick and easy way to avoid planning should be fading.

 

Husband and wife, in their 70s, claimed a farming operation for soybeans, but failed to plant for three years because of wet or dry conditions. They also had no records because of either a hurricane or a computer crash nor did they even attempt to reconstruct them. However, other farmers in the area planted 2 of those 3 years.

The court found the lack of attempt to adjust to agronomic conditions, lack of following local customs, and lack of actually performing the labor resulted in a tax shelter attempt. The tax court found no intent to profit from the operation, therefore, denied all deductions and disallowed the claimed loss from farming. Likewise in another case,, a horse purchasing, training and selling business was denied deductions because of lack of records, business plan or experience in the business of horses beyond riding them.

It is my belief these folks didn’t try even a little to show an effort or intent to farm. Planning and showing your efforts in advance would have likely had a different result. Inboth of these cases, the tax payers had substantial gains in other activities (presumably their day jobs). The more you make off farm income, the more important these records to prove your intention to profit.

 

 

Until 1987, passive loss rules allowed non farm investors to purchase farm ground and take losses to offset active income from other sources. Some believe that this is what lead to a large number of farm sights in the Midwest being allowed to slowly “rot on the vine” as investors took depreciation from buildings without any desire to put money into maintenance. The rule after 1987 hinges on whether or not the owner is “materially participating”. However, the rule was written before LLCs and LLPs existed. When challenged , the IRS maintained the rule applied to LLCs and LLPs just like other business entities. The tax court said no dice. The IRS was not allowed to automatically apply the rule to LLCs and LLPs. Instead, the court indicated that a determination of whether or not the interest of the member was truly limited had to be conducted. That makes each of the 50 state’s rules on LLCs and LLPs important. For example, in Iowa, members can have authority beyond what are considered limited interests. The court went on to essentially tell the IRS to get busy are create regulations that apply to LLCs and LLPs instead of dragging the matters through the Tax Court.