Life estate basis

[LindaK]

I plan to talk to the attorney regarding this but want to understand as much as possible before I do.

In 2008, my client and her sister became owners of remainder interest in farmland (Property A) from their parents. In 2010 (both parents still alive) the sisters bought out the value of the life-estate (calculated with value of land and age of parents) using borrowed money. So the sisters then jointly owned full interest in the land. The sisters also jointly owned another piece of land (Property B) received as a gift. In 2012 they separated the land so each sister now owns one piece of land. No money changed hands but her sister is now solely liable for the loan on Property A and my client has property B free and clear.

What information do I need to determine basis in property A? The buy-out price plus some value for the remainder interest? Is the remainder interest a gift using the parents' basis?

Could this be considered a like-kind exchange?

Thank you

[Roland Slugg]

The buy-out of the parents' interest terminates the life estate, of course. If the purchase price was less than the land's full FMV, which your OP suggests that it was, then what you have is a transaction that is part gift and part sale.

For the daughters -- Their starting basis is the total of: (A) the amount paid to obtain full fee title to the land, plus (B) a portion of the parents' basis in the land. The (B) portion is figured by multiplying the parents' basis in the land by a fraction, the numerator of which is (1) the FMV of the land as of the date of sale, minus (2) the selling price; and the denominator of which is the FMV of the land as of the date of sale.

Example:
Parents' basis in land = $10,000
FMV of land as of date of sale to daughters = $100,000
Amount paid by daughters = $25,000

The daughters' starting basis is $32,500, calculated as follows:
Cash paid = $25,000
Basis of gift portion = $7,500 [Calculation: $10,000 × $75,000 (i.e. $100,000 minus $25,000) ÷ $100,000]
Total = $32,500

For the parents -- They are treated as having made a gift and a sale. The portion to be reported as a sale (on Schedule D of their own tax return) has a basis of $2,500 (using the same values as above) and a selling price of $25,000 for a net LTCG of $$22,500.

The above is similar to the rules when there is a bargain sale to charity.

[LindaK]

Thank you, that makes sense. I hadn't taken the time yet to develop a formula.

Because there will be a large capital gain, I think reporting it as a Section 1031 exchange makes sense. Does the transaction need to be designated as such at the time or can we make the decision now? Do both parties have to report it that way, or could the other sister treat it as a sale and purchase? (I have nothing to do with the sister's tax preparation.)

[Burke]

A 1031 like-kind exchange cannot be done after the fact. In fact, I am not even sure this would have qualified. You must set up a 1031 ahead of time, the money has to go through a qualified intermediary, and there are time frames to watch for. It is done when one qualified property is sold, and another bought by the same person. The buyer/seller cannot take direct possession of the funds at any time.

[Roland Slugg]

You must set up a 1031 ahead of time, the money has to go through a qualified intermediary, and there are time frames to watch for.

That is all true, but only for non-simultaneous like-kind exchanges. Simultaneous LKEs do not require the use of a QI and are usually handled via a double escrow. Based on my reading of the OP it appears the transaction in question may have been a simultaneous exchange.