Rhea Jones, 75, lives in a beautiful coastal town in northern California. Rhea's home occupies three magnificent acres of bluff property overlooking 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.
Rhea's husband of 50 years, John, built the custom home 10 years ago. It was truly the realization of their lifelong dream. 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 cliffside home. Rhea's estate plan provides that the home, which is worth $3 million, passes to John and Rhea's favorite charity upon her death.
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 its annual fundraising 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.
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?
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 #1: In an ideal situation, an engineer or other person skilled in estimating the useful life of similar types of property determines the estimated useful life. In many instances, an engineer will likely determine a very long useful life. In fact, it is not uncommon for some personal residences to have useful lives of 50, 60, 70 years or more, which directly translates into a larger charitable deduction.
Option #2: Alternatively, an individual may request that an appraiser provide information regarding estimated useful life, since an appraiser is already valuing the property for income tax valuation purposes. See GiftLaw Pro Chapter 1.5.2 "Form 8283 and Appraiser Qualifications." In the event the appraiser is competent to provide useful life determinations, this is an excellent solution. However, many appraisers lack the experience or knowledge necessary to provide such uniquely detailed information.
In this case, Rhea's appraiser does not feel capable of determining the estimated useful life of her home. Thus, Option #2 is not going to solve the dilemma. As for Option #1, while use of an engineer to determine useful life is perhaps the most favorable option, this option is costly, time-consuming and burdensome. As a result, this option is rarely selected, except perhaps in multi-million dollar situations where the increased useful life will result in a significant five or even six figure tax savings.
Rhea prefers to keep things simple. Accordingly, she is not very excited about the cost and complexity of Option #1. However, she understands an engineer will likely provide a beneficial and defensible determination. Before she makes her final decision, she wants to weigh her other two options.
Editor's Note: There are four primary options for determining estimated useful life. This case study addresses the first two options. The remaining two options will appear in Parts 5 and 6 of this series. Keep in mind that for gifts of a remainder interest in land only (i.e., no building), depreciation will not be taken into account since there is no depreciable component to the contributed property, as land is not subject to depreciation.