Question:

Can the Section 121 $250,000 capital gains tax exclusion apply when home is the remainderman’s principal residence? The property is in a life estate and both the life tenant and the remainderman live in the home and are selling it together.

The remainderman meets the “use” test having lived in the property for at least two out of the previous five years. I am unclear about whether he meets the “ownership” test.

Second, if he does qualify for the Section 121 exclusion, is the following a correct calculation of the amount of gain he can exclude?

Assume: The house was sold in September 2024. At that time, the life tenant was 82 years old. She had paid $42,000 for the house and over the years made capital improvements totaling $58,000 with a resulting cost basis of $100,000.

The house was sold for $700,000 after the broker’s commission and other expenses, resulting in gain of $600,000.

Now it gets interesting, because we need to figure out the shares with the Life Estate in place at time of sale. IRS Publication 1547 says: “Internal Revenue Code (IRC) Section 7520 requires the use of an interest rate of 120% of the annual mid-term applicable federal rate for the month in which the valuation date falls.” The AFR is the minimum interest rate that the IRS allows for private loans. For September 2024, I believe the mid-term AFR is 4.02%. Source: https://www.pbgc.gov/prac/interest/historical-applicable-mid-term-rates. Using 120% of this, would bring the applicable rate to 4.8%. At interest rate 4.8% and at age 82, the Life Estate factor in IRS Table S 2010CM is 0.29308 and the Remainder factor is 0.70692. Source: https://www.irs.gov/retirement-plans/actuarial-tables.

Here is my attempt to calculate the capital gains taxes owed by 1) the life tenant, and 2) the remainderman for whom the home is also principal residence. Life Tenant’s share of capital gain = $600,000 x .29308 = $175,848. Remainderman’s share of capital gain = $600,000 x .70692 = $424,152.

Life tenant’s share of cap gain tax exclusion to be applied = $250,000 x .29308 = $73,270. Remainderman’s share of cap gain tax exclusion to be applied = $250,000 x .70692 = $176,730.

As a result, the life tenant capital gain gain less the applicable exclusion = $175,848 – 73,270 = 102,578 The remainderman’s capital gain less the applicable exclusion = $424,152 – 176,730 = 247,422

Applying the long-term cap gains tax rate of 15%., the life tenant will owe $15,387 in taxes ($102,578 x .15 = $15,387) and the remainderman $37,114 ($247,422 x .15 = $37,114).

Is this correct, or can both owners take advantage of the full $250,000 exclusion? Are there other, better alternatives, such as the remainderman deeding back his interest to the life tenant?

Response:

A great analysis and a lot of questions. I’ll try to take them one by one.

First, I also have not run across a situation where the remainderman of a life estate also lives in the property. But I don’t see any reason why they would not qualify for the Section 121 exclusion along with the life tenant.

Second, in terms of how the capital gains exclusion is allocated, the first step is to allocate the proceeds of the sale. Your calculations are accurate in this regard. The Section 7520 rate for September 2024 is 4.8%. Using the IRS Table S 2010CM spreadsheet, the life tenant’s interest at age 82 is indeed 29.3%. But here is where my approach is somewhat different from yours. These numbers should be used to allocate the sale proceeds and the capital gain, but not the $250,000 exclusion.

The life tenant should receive $205,100 of the $700,000 of proceeds, of which $175,800 is capital gain. She should be able to use her whole $250,000 exclusion against this amount and thus pay no tax. The remainderman should receive the balance of $494,900 of the proceeds, of which $424,200 will be capital gain. However, I see know reason why he cannot use his full Section 121 exclusion of $250,000 gain against this amount, leaving him having to pay tax on just $174,200 of gain. This is because he qualifies independently for the exclusion.

This may make your third question about how all this would work if the remainderman were to deed back her interest to the life tenant prior to sale. I think the life tenant would still be able to use her full $250,000 exclusion even though she would not have had full ownership during two out the proceeding five years. But the net result would be worse since they would lose the remainderman’s exclusion.