Case: Rhea Jones, 75, lives in a beautiful coastal town in northern California.
Rhea's home occupies three magnificent acres of bluff property that
overlooks the crashing waves of the Pacific. Since her home sits just
steps away from the dramatic cliffs, Rhea frequently jokes to her friends
about her "living on the edge" lifestyle.
John, Rhea's husband of 50 years, built the custom home ten years
ago. It was truly the realization of a lifelong dream of John and Rhea.
Unfortunately, John passed away unexpectedly five years ago. Now, Rhea
lives alone in the large home. Nevertheless, Rhea is looking forward to
spending her remaining days in this lovely home. Not surprisingly, she
frequently plays host to her children, grandchildren and friends.
Rhea is an active philanthropist. In fact, she spends three days a week
volunteering with local charities. While very wealthy and philanthropic,
Rhea makes only modest yearly gifts. However, she intends to make a substantial
bequest upon her death. Specifically, Rhea plans on distributing her entire
estate to her children and grandchildren, except for her cliff-side home.
Rhea's will provides that the home passes to John and Rhea's favorite
charity upon her death. The home is worth $3 million.
However, at a recent estate planning presentation, Rhea discovered the
benefits of a gift of a remainder interest in a personal residence. In
particular, she liked the potential significant tax savings and the home's
avoidance of the probate process. Also, because the gift is irrevocable,
the local charity would recognize and honor Rhea for her generous gift
at the annual fund raising gala. Of course, Rhea would retain the right
to live in her home for the rest of her life, which is an absolute requirement
to any potential gift arrangement.
Question: Rhea is very excited about this gift arrangement, but she has many questions.
Before she commits to the gift plan, she wants to address several issues.
In order to compute the charitable income tax deduction, Rhea is required
to determine the estimated useful life of her home. How does she do this?
Are there some rules regarding this determination? What are the four basic
options to make this determination?
Solution: In determining the value of a gift of a remainder interest in a personal
residence or farm, depreciation must be taken into account if any part
of the contributed property is subject to exhaustion, wear and tear, or
obsolescence. See Sec. 170A-12(b)(1). The tax code requires the straight-line
method of depreciation. In order to compute depreciation, a donor must
determine the estimated useful life and salvage value of the building.
"Estimated useful life" is the estimated period of time that
an individual's property may reasonably be expected to be useful.
In determining this time period, the "expected use" of the property
must be taken into account. See Sec. 170A-12(d). Lastly, the useful life
"clock" starts ticking at the time of a gift and not at the
time the property is built.
Option #4: Finally, at the option of an individual, the estimated useful life can
be an asset depreciation period that is within the permissible asset depreciation
range for the relevant asset guideline class. See Sec. 170A-12(d). In
other words, an individual can borrow a depreciation useful life recovery
period and use it for purposes of determining the building's estimated
useful life. For example, the depreciation recovery period for residential
rental property is 27.5 years. Thus, when computing the charitable deduction
for a gift of a remainder interest in a personal residence, Rhea could
simply use 27.5 years for the building's estimated useful life.
The option to select a depreciation recovery period for residential rental
property when determining the useful life of residential non-rental property
is very favorable for the government. In exchange, this option creates
in essence a "safe harbor" for individuals. In short, this option
is very safe, but may cause an individual to claim a lesser charitable
income tax deduction than they are entitled to claim.
First, it assumes an unfavorable characteristic upon the individual's
building – that it will be used as rental property. Most will agree
that rental property, in general, suffers more wear and tear than non-rental
property. Yet, in most cases, an individual will remain in the personal
residence until death or other disposition. Furthermore, the tax regulations
specifically state that the estimated useful life shall take into account
the "expected use" of the property. See Sec. 170A-12(d). However,
by borrowing the depreciation recovery period of residential rental property,
an individual is losing the added benefit of the "actual use"
of the property. Thus, an individual is settling for a shorter useful
life determination than provided by the tax regulations or real life experiences.
Second and most importantly, this option results in a smaller charitable
deduction. For instance, depending greatly on the land and building value
in each situation, the charitable deduction may shrink about 2-5% in comparison
to a 45-year useful life. If the overall property value is $100,000, the
charitable deduction may fall a modest $2,000 - $5,000. However, if the
overall property value is $1,000,000, the charitable deduction may fall
a significant $20,000 - $50,000. Therefore, an individual may potentially
lose significant tax savings if the 27.5-year useful life is selected.
Yet, as stated above, the "safe harbor" 27.5-year useful life
selection is a very safe and conservative choice. So, if the size of the
charitable deduction is less important or the charitable deduction is
unable to be utilized, the 27.5-year useful life selection is an excellent option.
Thus, with four different options to choose from, Rhea visits with her
attorney again to discuss the best option for her situation.
Living on the Edge, Part 5
Living on the Edge, Part 4
Living on the Edge, Part 3
Living on the Edge, Part 2
Living on the Edge, Part 1