What are the Tax Implications of the Growth in Value of Life Interest in Real Estate in Trust?
My mother passed away two years ago and she left her husband a life estate in their primary residence via her Living Trust. The Trust designated my sister as the Trustee after my mother’s passing. My sister and I are the two remaining beneficiaries. The life estate property is located in Arizona and my sister resides in California and I reside in Puerto Rico. My question relates to potential capital gains tax liability for both the trust and my sister and myself when the life estate property is sold after the life estate tenant’s death.
The life estate property value has increased approximately 4% annually over the last two years which is average for the area. The value of the property was approximately $700,000 at the time of my mother’s passing. Hence, the current property value is approximately $728,000. Estimating the life estate tenant lives another 10 years and the property continue to appreciate by 4% annually the approximate property value would be $1,077,618 upon my mother’s husband’s death. Hence, the increase in value from the date of my mother’s passing to the life tenant’s death 12 years later is approximately $377,618. Will my sister and I incur capital gains tax equally (50%) of this appreciation and is this taxed separately by the IRS and state of Arizona?
Yes, that’s right. While the basis in the property was adjusted (“stepped up”) upon your mother’s death to its fair market value at that time, it won’t be stepped up again upon her husband’s death because it’s not in his taxable estate. You and your sister will have to pay federal taxes on the capital gain which, as you suggest, will be the difference between the net proceeds of the sale (after the real estate agent’s commission) and the basis — the value upon your mother’s death. As you also suggest, you’ll each be responsible for half the gain.
While I have no knowledge about the Arizona tax system, I don’t think you will have to pay any tax to the state of Arizona since neither you nor your sister live there, but you very well may owe tax to Puerto Rico (which seems to really need it right now) and your sister to California.