Does an Implied Life Estate Qualify for a Step-Up in Basis?

When a property owner transfers real estate but continues to use it as if they still own it, tax questions arise. A key issue is whether an implied life estate allows for a step-up in basis when the original owner dies. This can significantly impact capital gains taxes for heirs who sell the property.

Understanding the tax implications requires examining ownership structure, transfer classification, and estate tax rules.

Real Estate Title Treatment

How property ownership is structured determines tax consequences, especially when an implied life estate is involved. Title treatment affects whether a property is included in a decedent’s taxable estate and whether heirs receive a step-up in basis.

If an owner transfers property but continues to live there without a formal life estate agreement, the IRS may still treat the arrangement as a life estate. This depends on factors like retained control, payment of property taxes, and continued use as a primary residence. If these conditions apply, the IRS may include the property in the estate under Internal Revenue Code (IRC) 2036(a), which applies when a person retains possession or enjoyment of transferred property.

State laws also influence ownership classification. Some jurisdictions recognize implied life estates based on continued occupancy and financial responsibility. If the property is included in the estate under IRC 2036(a), heirs typically receive a step-up in basis, reducing capital gains taxes when selling the property.

Transfer and Gift Classifications

How a real estate transfer is categorized determines whether it triggers immediate tax consequences or defers them until the original owner’s death. The IRS differentiates between completed gifts, retained interests, and transfers that may not qualify as true under tax law. If a property owner conveys title but continues using the home as before, the IRS may consider the transfer incomplete, subjecting it to estate inclusion rules.

A completed gift under IRC 2503 requires the donor to relinquish all control and beneficial interest. If the original owner retains significant rights—such as living in the home rent-free—the IRS may argue no true gift occurred. Completed gifts are subject to federal gift tax, while incomplete transfers may still be taxed as part of the estate under IRC 2036.

If a transfer is a completed gift, its value is determined at the time of transfer, and the donor may need to file a gift tax return (Form 709) if it exceeds the 2024 annual exclusion limit of $18,000 per recipient. Gifts above this threshold reduce the donor’s lifetime estate and gift tax exemption, set at $13.61 million in 2024. If the transfer is incomplete due to retained control, the property remains part of the taxable estate, and its value is assessed at the date of death.

Some property owners use qualified personal residence trusts (QPRTs) under IRC 2702 to transfer a home while retaining the right to live in it for a set period. This reduces the taxable value of the gift. If the owner outlives the trust term, the home passes to beneficiaries at a lower tax cost. If not, the property is included in the estate, potentially qualifying for a step-up in basis.

Step-Up Basis Implications

When an inherited property qualifies for a step-up in basis, its tax basis is adjusted to its fair market value as of the owner’s date of death. This can significantly reduce capital gains taxes when heirs sell the property. Instead of paying taxes on the difference between the original purchase price and the sale price, heirs are taxed only on appreciation after inheritance.

Whether a property receives this adjustment depends on whether it is included in the decedent’s taxable estate. Under IRC 1014, assets in the estate generally qualify, but complications arise when ownership is transferred before death. If the IRS deems the transfer incomplete due to retained control, the property may still be considered part of the estate, allowing heirs to benefit from the step-up in basis. If a transfer is recognized as complete, the recipient takes on the original owner’s basis, potentially leading to higher capital gains taxes.

The timing of a sale after inheritance also affects tax treatment. If heirs sell shortly after inheriting, little to no taxable gain may exist due to the stepped-up basis. However, if they hold the property and it continues to appreciate, future gains will be subject to capital gains tax. The long-term capital gains tax rate in 2024 ranges from 0% to 20%, depending on taxable income, with an additional 3.8% net investment income tax potentially applying to higher earners.

Estate Tax Position

The inclusion of a property in a decedent’s taxable estate affects more than just the step-up in basis. For estates exceeding the federal estate tax exemption—set at $13.61 million per individual in 2024—any value above that threshold is subject to a 40% estate tax.

Property valuation plays a major role in determining tax liability. The IRS may challenge valuations that appear artificially low, particularly when discounts are applied for lack of marketability or minority interest in family-held entities.

Estate tax planning often involves structuring ownership to minimize exposure. Irrevocable trusts, such as grantor retained annuity trusts (GRATs) or intentionally defective grantor trusts (IDGTs), allow property to be transferred while freezing its value for estate tax purposes. These structures can be effective for appreciating assets, as they remove future appreciation from the taxable estate. However, improper execution—such as failing to adhere to formal trust requirements or retaining excessive control—can lead to IRS scrutiny, potentially pulling the asset back into the estate under IRC 2036.

Filing and Documentation Factors

Proper documentation is essential when an implied life estate is involved. The IRS may scrutinize transfers where ownership was transferred but the original owner retained use of the property. Clear records help establish whether the transfer was a completed gift or should be included in the estate.

Estate executors and heirs must ensure all relevant tax forms are filed correctly to avoid disputes or penalties. Form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return, is required for estates exceeding the federal exemption threshold and must include a detailed valuation of all assets, including real estate. If the IRS determines a property was improperly excluded, it may impose additional taxes and interest. Supporting documentation, such as appraisals and property tax records, can help substantiate claims regarding ownership and control.

For transfers classified as gifts, Form 709, the Gift Tax Return, must be filed if the value exceeds the annual exclusion amount. Failing to report a gift can lead to penalties and complications when settling the estate. If heirs sell the property after inheriting it, they may need documentation proving the step-up in basis, such as an appraisal conducted at the owner’s death. Keeping thorough records ensures compliance with tax laws and minimizes the risk of IRS challenges.