Residence That Was Transferred to Children Was Includable in the Taxable Estate
A frequently used estate planning technique is the transfer by an individual of ownership interests in his or her home to family members. This technique is designed to permit a discounted valuation for gift tax purposes for the interests transferred, or to remove subsequent growth in the value of the home from the estate. This strategy also permits a discounted valuation for estate tax purposes for the interest in the residence that the individual owns, if any, at the time of his or her death. In Estate of Tehan, 1 the Tax Court recently held that interests in a residence transferred by an individual during his lifetime to his children were includable in his estate under Section 2036(a)(1) because the individual retained possession and enjoyment of the residence without paying fair rental value.
In 1990, Mr. Tehan purchased a condominium for his personal use. In 1997, he entered into an agreement with his eight children regarding the use and occupancy of the condominium. The agreement provided that Tehan would have the sole and exclusive right to the use and occupancy of the condominium for as long as he desired. According to the agreement, Tehan would be responsible for the payment of any mortgage encumbering the property, the condominium fees, real estate taxes, property insurance, and all costs and expenses related to the maintenance and repair of the condominium.
The agreement provided that when Tehan no longer occupied the condominium, its costs and expenses would be divided among the owners in accordance with their ownership interest in the condominium. The agreement also provided that when Tehan no longer occupied the condominium, it would be sold and the net proceeds from the sale would be allocated and distributed among the owners in accordance with their ownership interest in the condominium.
In 1997 and 1998, Tehan gave a 4.5% interest in the condominium to each of his eight children as tenants-in-common. In 1999, Tehan gave away his remaining ownership interest in the condominium by gifting a 3.5% interest in the condominium to each of his eight children. Following the 1999 gift, Tehan had no ownership interest in the condominium. Tehan died in 1999.
From the time of the first gifts to his children in 1997 until his death, Tehan continued to use and occupy the condominium. The fair rental value of the condominium was between $1,600 and $2,200 a month. Tehan paid monthly expenses related to the condominium of approximately $900 per month, excluding utilities, and about $1,000 to $1,100, including utilities. During Tehan's life, his children never used the residence, nor paid any of the expenses related to it, nor attempted to sell it.
In a notice of deficiency, the IRS included the condominium in Tehan's estate under Section 2036(a)(1). Section 2036(a)(1) includes in a decedent's gross estate property transferred by the decedent during his lifetime if there existed at the time of the transfer an agreement, either express or implied, that the decedent would retain possession or enjoyment of the property transferred, even if the agreement was not legally enforceable by the decedent.
The estate's argument against inclusion was based on the common law principle that tenants-in-common have the non-exclusive right to use and enjoy property and are obligated to contribute on a pro rata basis to the expenses of the property. The estate argued that Tehan, in order to acquire the exclusive right to the possession of the condominium, contractually agreed with his children to pay all of the expenses related to the condominium.
The court refused to accept that these contractual payments by Tehan were sufficient to avoid including the condominium in Tehan's gross estate under Section 2036(a)(1). The court quickly concluded that Tehan retained possession and enjoyment of the condominium. The court based its decision on the fact that there was an express agreement between Tehan and his children entitling him to continue using and occupying the condominium, to pay all the monthly expenses of the condominium, and to treat the condominium as he had done before the transfers.
The estate relied on the case of Estate of Barlow, 2 which the Tehan court distinguished. In Barlow, the decedent and his wife gratuitously transferred a farm to their children and simultaneously entered into a lease with their children with respect to the farm. The court in Barlow held that the farm was not included in the gross estate because the continued use and possession of the farm by the decedent and his wife was obtained in exchange for a fair and customary rent. The court in Tehan stated that unlike the situation in Barlow, Tehan did not enter into a lease with his children and did not agree to pay fair rental value for his use of the condominium.
Tehan illustrates that the technique of transferring ownership interests in a residence must be planned properly. Proper planning would include entering into a written lease containing the usual and customary terms found in a lease and providing for the payment of a fair rental value. The fair rental value should be established objectively from a qualified appraiser. The costs and expenses of the residence should be paid by all the owners in proportion to their ownership interest in the residence. If these steps are taken, the unfortunate tax consequences experienced by the Tehan family should be avoidable.
1 TC Memo 2005-128, RIA TC Memo ¶2005-128, 89 CCH TCM 1374.
2 55 TC 666 (1971).
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.