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Recoup ‘life estate’ maintenance costs

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POSTED July 21, 2011 7:19 p.m.

DEAR BENNY: We have an unusual situation. When my dad died, he left a life estate in a house/rented duplex to his widow. My sister and I have managed the duplex for 12 years, with all income going for repairs and any surplus to the widow. We would like to be done with it. His widow does not want to move.

We are planning on putting it on the market, subject to the life estate. Do you have any guidelines on how much the life estate devalues the property? She is 76, and as far as we know, healthy as a horse.

Also, I’ve been told a bank won’t loan on a property with a life estate, so that doesn’t help us much, either.

Although we know we could just let her handle everything, we prefer to keep on top of duplex maintenance, taxes, etc., and so we are hands-on. Alternatively, if we can’t sell the property, can you suggest a fair and reasonable fee, as called for in the trust documents, to charge for taking care of maintenance and upkeep on this property? For 12 years we haven’t charged anything. So far every agent we’ve talked to is stumped. --Linda

DEAR LINDA: The best person to know if there is a market for this type of investment would be a real estate broker or a real estate investment company. However, unless the price for the property is so low that it will be attractive to a speculator, I seriously doubt that you will be able to sell.

The value of the life estate can be determined by looking at actuarial tables in the Internal Revenue Service code. You can find these in IRS Publication 1457, entitled “Annuities, Life Estates & Remainders.” However, different states may adopt different ways of valuing the life estate and the remainder interest, so you should consult with a local accountant familiar with this issue.

At age 76, the life estate probably still has significant value. The costs of upkeep, taxes, maintenance, etc., are of course the responsibility of the life tenant. So you may have some claim to reimbursement for those expenses depending on what the trust agreement states.

The trust language would control regarding payment of expenses, and who is responsible for those payments. However, every state has a statute of limitations. This means that after a set number of years (often three years) you lose your right to make a claim.

So if your state has a three-year statute, you can demand only that the widow reimburse you going back three years. You might want to consider starting to demand reimbursement now, so that you will not lose any more years.

You asked what a reasonable fee would be for your services. If the trust is silent, but says the life tenant is responsible for expenses, a “reasonable fee” would be the taxes, maintenance and upkeep.

It really depends on the specific language of the trust and/or the document setting up the life estate, and your own state law.

DEAR BENNY: My wife and I rent a home owned equally by our two children as a result of a personal residence trust that gifted the house to them. We may one day need to move into a retirement facility. One of our children lives in another distant state and has a family, so it would be most unlikely for him to occupy the home.

However, our other child lives in our city and could consider moving into the home for two years to receive the $250,000 exemption upon its future sale. What is the impact on the child who will not be occupying the home? --Sam

DEAR SAM: A personal residence trust (PRT) or a qualified personal residence trust (QPRT) is created for a term of years. Generally, as long as the property is held in a PRT, the trust is the property owner -- not the beneficiaries (in your case your two sons).

However, because you state that you are paying rent, I have to assume that the term of the trust has expired, in which case your sons now own the property.

There is a potential tax problem with PRTs -- namely, that the tax basis of the grantor (i.e., you) becomes the tax basis of your beneficiaries (i.e., your sons). So if your sons sell the house, they have to be concerned with tax issues. However, there is a tax break for homeowners -- namely, that a certain portion of your profit can be excluded from capital gains tax.

If the homeowner has owned and lived in the house for two years out of the five years before it is sold, he/she can exclude up to $250,000 of any gain. If you are married, and your spouse has lived in the house for the same two-year period, you can exclude up to $500,000 of your gain.

Your son who will live in the house will be able to take this exclusion if he meets the “ownership” and “use” tests described above. However, the son who will not live in the house will have to pay capital gains tax. And because his basis will be your tax basis, he may end up having to pay a large number to the IRS.

DEAR BENNY: We lost my father last year and are taking his name off of the loan and adding my name. Our mother was granted a modified loan in the amount of $70,000. She has just received a tax bill for that amount. I thought the banks were no longer able to consider this a gift, or money earned? Can the IRS tax her for this? --Sherrie

DEAR SHERRIE: Are you sure that your mother received a “tax bill”? Could it have been IRS Form 1099-C? Lenders who cancel, forgive or even modify a mortgage loan in an amount of at least $600 are required by law to file with the IRS Form 1099-C. The “C” stands for “cancellation.”

As strange as it may seem, many borrowers who lost their homes at a foreclosure sale -- or sold it through a short sale -- may be obligated to pay tax on this canceled or modified debt. I call it “phantom income.”

However, there are some exceptions to this. First, if you are insolvent, and can prove this to the IRS, no tax is owed. Second, if you file bankruptcy before the debt is canceled or modified, you do not have to pay this phantom tax.

These two exceptions have been in the law for some time. However, in 2007, when the mortgage crisis began and thousands of homes were being foreclosed on, Congress thought it was insane to add insult to injury by taxing people whose homes had been foreclosed upon -- or where there was a loan modification or even a short sale.

Accordingly, Congress enacted the Mortgage Debt Relief Act of 2007. Oversimplified, if your principal residence was foreclosed up (or there was a loan modification or a short sale), you did not have to pay any tax. However, there is at least one catch: Let’s say you refinanced in 2005, and pulled out some of the home equity.

If the money you pulled out went to improve your house, then there is no taxable consequence. But if you used the moneys for other purposes -- a trip to the beach or college tuition for your daughter -- those funds, when canceled or modified, are still subject to tax. And unless Congress extends it, the law will expire at the end of 2012.

Talk to your own tax adviser; also look at IRS Publication 4681, entitled “Canceled Debts, Foreclosures, Repossessions and Abandonments.”

DEAR BENNY: My wife and I have been discussing rolling over an IRA and a 401(k) from my wife’s employer. Do you have experience or knowledge of ERSOPs? We are unclear if this is legal and do not want to pay penalties or taxes if this is not legitimate. We would like to invest directly in rental/income properties. --Mark

DEAR MARK: I do know that some pension plans allow investment in real estate, but I am not that familiar with all of the legal issues involved. You are correct to be concerned, because if you do not follow the rules, you can be hit with large penalties.

I would talk with the pension person or company who handles your wife’s 401(k). I would also find a pension specialist in your area and buy an hour of his or her time to get the correct answers.

However, make sure that the specialist you retain does not also sell products, such as stocks, bonds or even real estate. You want a totally independent person to assist and advise you. Search on the Web for “pension specialists.”

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