Capital gains on sale of life estate and primary residence exclusion; transfer back to life tenant before sale

[JeffCPA]

Fact pattern:   Husband and wife own their residence. They have owned their residence since 1996.  In 2019, husband and wife sign a deed that transfers their residence in fee simple (meaning outright and without restriction) to their two adult daughters.  But husband and wife retain a life estate for themselves. 

Husband and wife continue to reside at and occupy the property as their residence.   Wife dies in 2021.  Husband continues to occupy and live at the residence as his primary residence. 

October 2025, daughters sign a deed transfer their interest in the property back to their father/husband.  So, fatherhusbanbd (now widower) is now the sole owner of the property. 

In November 2025, Husband/Father sells the residence to third party and moves out. 

We know that if daughters had not signed a deed transferring property back to their father, and it was sold with father only owning a life estate, that the capital gain on the sale would have to be allocated between father and daughters, using IRS actuarial tables.   Father's capital gain would qualify for home sale residence exclusion.   At least I think that is what is supposed to happen.

However, upon transfer of ownership by daughters back to their father, and fathre then selling the home, I have the following questions:

1.  Does all of the capital gain on the sale of the home get allocated to him?  I assume yes.

2.  Is he allowed to claim the full $250,000 capital gain exclusion for residence?   He certainly use the residence for well more than 2 of the last 5 years, but as a life tenant for that time frame, he did not own the residence for 2 of those 5 years.   Yet if property had been sold with him as a life tenant, he would have been able to use the exclusion for his allocated capital gain.

It is just seeming too easy a fix to me for the daughter's to sign the property back to their father, a month before the sale, and by doing that now of the gain is their (and of course, they are not receiving any proceeds of the sale), and father is put back into place as owner being able to claim the exclusion.

Thoughts please.  Thank you community.     

[TaxGuyBill]

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@JeffCPA wrote:

but as a life tenant for that time frame, he did not own the residence for 2 of those 5 years.       

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I am not an expert for this, but it is my understanding that as a Life Estate holder, he *IS* considered an owner (which is the Life Estate holder is subject to tax if sold before death and why a property gets a Step-Up when the Life Estate holder dies).

[JeffCPA]

Thanks Tax Guy Bill.   Appreciate the information.   Jeff

[IRonMaN]

I hope Bill is right since that is the way I have been treating life estates since I have been doing this gig 😀

[BobKamman]

"as a life tenant for that time frame, he did not own the residence for 2 of those 5 years. Yet if property had been sold with him as a life tenant, he would have been able to use the exclusion for his allocated capital gain."

Exactly.  So maybe he can claim the exclusion only for what would have been his share of the gain had the daughters not returned their interest.  It's highly unlikely that an IRS auditor would end up with this return, but I would expect to hear "substance over form" right away.  Followed by an assertion of the "step transaction" rule:

The IRS step transaction doctrine is a judicial principle allowing the IRS to collapse a series of separate, intermediate steps into a single, integrated transaction for tax purposes. It prevents taxpayers from using convoluted, multi-step transactions to avoid taxes when the substance of the transaction indicates a direct, taxable path.

Your question really asks, "does this smell right?"  The answer is we smell something too, and IRS definitely would if they got involved.  Which is unlikely, and they might not succeed anyway.  

Incidentally, you need to read more Code and less IRS guidance.  There is no such term as "primary residence" in Section 121.  It's "principal residence."  

[JeffCPA]

Thanks Bob for this analysis.   Sorry I am not reading enough of the IRS Code.  Seems like the words, "primary" and "principal" in this context, mean pretty much the same thing. 

[JeffCPA]

Hello Bob.   I was re-reading your response, and I have a few follow up questions/comments that your response raises for me.

1.   If this were a tax return you were preparing yourself, how would you handle this situation?   Would you complete the return using the approach you indicate could be used, where only the capital gain that would have been allocated to the father had the daughters not returned their interest, be excluded from taxation?

2.  You commment that if the IRS were to actually audit this return, and challenge what was done here under the step transaction doctrine (which admittedly the likelihood of an audit is remote), that "they might not succeed anyway."     Would you be willing to share your thoughts/thinking analyzing why the IRS might not succeed in such a challenge.   

Thanks for your consideration in thinking about this matter further.   I have to admit I am very torn about what to do in completing this return for this client.    Jeff

[BobKamman]

1)  I don't make decisions like this.  The decision is up to the client.  Some clients are more risk-averse than others.  Who's the client here anyway?  The fiduciary for the father's estate?  And that fiduciary has to answer to two beneficiaries, right?  And pay the tax if the estate loses.  What if one of the beneficiaries is running for state Senate and files financial disclosures?  Maybe you have an oppo-research situation lurking.  "Depends on the facts and circumstances" applies not only to tax questions, but to tax clients themselves.

2) I don't give much thought now to something that might happen in the future.  Choose the best argument  when the time comes.  There might be case law by then.  Maybe "substance over form" -- they didn't really intend to give up any ownership interests, they weren't trying to qualify for long-term care assistance, it was just a way to avoid probate.  

[Skylane]

I got from guidance from an estate attorney and EA a few years ago that a life estate is considered an ownership interest for the purposes of Section 121, his years spent as a life tenant count toward the 2-year ownership requirement. When he acquired the remainder interest in 2025, he didn't "start" his ownership clock; he simply consolidated his existing ownership interest into a full fee simple interest. While unverified, I’d present both to the client as @BobKamman suggests.

[BobKamman]

Qualifying for the two-year ownership requirement is not the issue.  The gray area is his basis -- the whole enchilada, or just the remainder interest he held until (apparently) they discovered the tax problem once the sales contract had been signed but before the closing date.  Incidentally, who signed the contract -- just Dad, or the daughters as well?  An IRS auditor would want to see the document.  

[JeffCPA]

Hi Bob.   A few more details that I have to fill in the gaps, and I seek your views on cost basis step up in this scenario.   The father of the two adult daughters is 90 years old, and I have a copy of the actual real estate sales agreement, and he the father did sign the sales agreement alone.   So, the sales agreement was signed after the daughters signed the October 2025 deed transferring their remainder interest back to Dad.   Dad now owns entire fee simple interest in property, and he signs the sales agreement a few weeks later. 

Here is another question for you, given your comments about cost basis---which I agree with cost basis is, and calculating that is where the rubber meets the road. 

But what of this situation:

1.  Husband and wife bought this property in 1996.  

2.  It is 2019, when Husband and Wife execute a deed transferring ownership to their daughters, but retaining their life estate. 

3.  Wife dies in 2021, survived by husband, who is now the sole life tenant.

4.  Daughter's execute deed in October 2025 gifting their remainder interest back to Dad/widowed husband.

5.  Dad's sells property in December 2025.

As I calculate the cost basis for this property, am I allowed to do a 50% step up in cost basis using fair market value of property when wife died in 2021.   Certainly, if husband and wife were the outright owners of this property all along (Husband and wife live in MD), I would be doing that.  But in 2021 when wife dies, Husband and Wife are life tenants.   I am questioning whether a 50% step up in cost basis for wife's share of property at that point is permissible.   I am thinking it is not.    

Your thoughts?   Thanks for any input. 

[BobKamman]

@JeffCPA I'd have to look that up, but I think that since the  value would be included in the mother's estate (federal estate tax purposes), her half interest would get stepped-up basis.  

When was the listing agreement signed, and by whom?  Was it a sharp Realtor who suggested getting the property just in Dad's name?