Estate planning for unmarried couples, whether they are of the opposite sex or the same sex, is challenging from a tax perspective. Upon the death of the first partner to die (we will call this person the “deceased partner”), his or her estate is not entitled to the benefit of the unlimited marital deduction from estate taxes for assets passing from the deceased partner to his or her surviving partner. In addition, there is no exemption from property tax reassessment for California real estate transferred to the surviving partner (who is not a registered domestic partner). This means that the real estate transferred to the surviving partner will be reassessed to its current fair market value for property tax purposes upon the deceased partner’s death. The reassessment could cause a significant increase in the annual property tax bill for the real estate. Furthermore, estate planning in this situation takes on an added level of complication when one partner has children who will also be inheriting the same property upon the death of the surviving partner.

These issues are highlighted in the case of Betty Brown and Bobby Smith. Betty and Bobby are not married and have happily lived together for the past 10 years. Betty has two adult children, Dick and Jane, from a former relationship. Bobby has no children. Betty owns a home, a vacation home, some stocks, and an IRA. Bobby has some assets of his own. At this time, the collective value of Betty’s assets is less than the current estate tax exemption amount, so she will not have an estate tax assessed against her estate if she died this year. (Note that if the estate tax exemption amount decreases in future years, Betty’s estate could be subject to estate taxes.)

Betty tells her estate planning attorney that she would like to have an estate plan prepared that provides that if Bobby survives her, he will have the right to live in the vacation home until he moves out or dies.  Upon the termination of Bobby’s interest in the vacation home, it will pass to Betty’s children. She also would like the children to have the right to use the vacation home for four weeks each year. All expenses to maintain the vacation home are to be paid by Bobby and she would like him to be able to get the deduction for real estate taxes on his federal income tax return. Betty tells the estate planning attorney that she read a great article recently saying that this type of arrangement can easily be set-up by giving Bobby a life estate in the deed to the vacation home.

The estate planning attorney informs Betty that informally structuring this arrangement as a life estate (without the use of a trust) may cause problems. There are many “pitfalls” for the unwary when giving a life estate to the surviving partner without defining the scope of the arrangement. Those pitfalls include:

1.         Unexpected Gift Taxes If Bobby Terminates the Life Estate Prior to His Death. If Bobby “moves out” and terminates the life estate before his death, he has potentially made a taxable gift to the children. The amount of the gift would be the value of the life estate at the time he moved-out. To the extent that the value of the gifts to the children exceed the annual exclusion amount multiplied by two (the number of children), Bobby has made a taxable gift.

2.         Unexpected Gift Taxes If Bobby Pays the Principal on the Mortgage. If Bobby pays the principal portion of the mortgage (i.e., reduces the amount of the mortgage on the vacation home), he will be making a taxable gift to the remainder beneficiaries (i.e., the children).  This issue can also be avoided under a properly drafted trust instrument.

3.         Foreclosure or Disrepair. Problems could arise if the vacation home is subject to foreclosure due to Bobby’s failure to pay the mortgage or if Bobby fails to maintain the vacation home in good repair. These issues may be addressed in the trust instrument by providing that if there is a foreclosure or if the vacation home falls into disrepair, Bobby will be treated as if he died and his interest in the vacation home will terminate at that time.

4.         Property Tax Reassessment. The primary concern facing non-married partners who transfer real estate to the other is the change of ownership on the transfer that leads to a reassessment of the property for property tax purposes. One way for the couple to avoid an increased property tax bill on such a transfer is to get married or to file as registered domestic partners before the transfer; this is because there is an unlimited property tax exemption for transfers of California real estate between spouses and registered domestic partners. However, if the couple is not so inclined to legally acknowledge their relationship, there is another way to avoid property tax reassessment on the transfer of the California real estate to the surviving partner. That way is to transfer an interest in the property to the surviving partner for a term that is less than 35 years. There is an exemption from the reassessment rules for property tax purposes where the transfer of the interest in California real estate is for a term that is less than 35 years. So, in our example, Betty’s trust could provide that if Betty leaves an interest to Bobby in the vacation home for 34 years, the vacation home will not be reassessed for property tax purposes. If Betty and Bobby die in the normal course and Bobby survives Betty, it is likely that a 34 year interest in the vacation home could be the equivalent to a life interest for Bobby given his remaining life expectancy at the time his term interest begins.

As you can see, there are many issues to address when transferring assets to an unmarried partner at death. It is important to meet with an estate planning attorney to prepare a trust that properly addresses these issues in order to avoid unexpected consequences and taxes.

If you would like to discuss this or other trusts and estates issues, please contact the attorneys at Drucker Law Offices, 468 North Camden Drive, 2nd Floor, Beverly Hills, CA 90210, 310.285.5375 Tel, 310.444.9754 Fax, www.druckerlaw.com