It is common that real property held in a deceased estate is left to the beneficiaries of the deceased estate. The beneficiaries may have the property transferred into their names, or the property may be sold with the sale proceeds distributed to the beneficiaries.
An alternative arrangement is that a person may be left a life interest in the real property.
A person with a life interest is allowed to live in and use a property for their benefit. The person does not become the owner of the property, which makes life interests a flexible way to look after another person without transferring ownership or triggering a capital gains event.
Dealing with a life interest in property isn’t something you, your clients, or even bankruptcy Trustees encounter very often in Australia. However, there are some important points to note should you come across one.
In this article, we discuss what a life interest in property is, how it differs from a right to reside, and how the interest is handled in bankruptcy.
What is a Life Interest in Property?
A life interest grants the beneficiary (known as the “life tenant”) the right to use real property after you pass away, without granting them ownership. The beneficiary can:
- Occupy the property
- Lease the property
- Sell the property
Life interests are established as a trust in your Will. When you pass away, any property in the trust remains part of your estate, but the life tenant is granted the right to use the property for their benefit.
Creating a life interest is a way to provide for someone after your death. This can be useful when you want to look after a loved one (e.g. your spouse), but you ultimately want the property to be left to someone else.
For example, the owner of the family home may create a life interest for their spouse. When the owner passes away, the life interest allows the spouse to live in the family home without transferring ownership and triggering a capital gains event. Once the life interest ends, the family home is distributed according to the terms of the Will.
When Do Life Interests in Property End?
Life interests in property typically last for the duration of the tenant’s life. A life interest can be conditional and may end earlier.
The testator (the person creating the Will) has discretion to place conditions on a life interest. Common situations where a life interest ends early may include:
- Where the property is not maintained correctly
- If the tenant moves out or sells the property
- If the tenant moves to aged care
- After a set period of time
What Happens When a Life Interest in Property Ends?
When a life interest ends, the property is dealt with according to your Will. The property does not become part of the life tenant’s estate. In most cases, the remaining property is distributed to the beneficiaries of your Will.
Can You Sell a Property With a Life Interest?
It is possible to sell a property with a life interest. However, selling the property requires an agreement between the life tenant and remainderman.
It is more common for the remainderman to sell their interest in the property.
Unfortunately, the market to sell a life interest in a property is limited due to the interest in the property returning to the deceased estate after the life interest ends. Usually, the most viable option for selling a life interest in property is to sell it to the remainderman.
How is a Life Interest Valued?
There are a number of methods that can be used to value a life interest in a property to ensure the interest is sold for a fair value.
The most common method for valuing a life interest is a discounted cash flow method. This involves assessing the net cash flow that can be generated from the property – often rental income less maintenance and management costs – and discounting these cash flows to their present value.
Adjustments to the value of a life interest may also be applied to account for the age and health of the person holding the life interest.
Tax Implications of Life Interests in Property
Life interests in property can have important tax consequences for both the estate and the beneficiaries. While granting a life interest does not transfer legal ownership, it can still affect how capital gains tax and other liabilities are treated.
In many cases, creating a life interest in a principal residence can defer capital gains tax that would otherwise arise if the property were transferred outright. However, tax outcomes depend on factors such as whether the property is later sold, rented, or used to generate income.
There may also be implications for land tax, council rates, and aged care means testing for the life tenant. In addition, selling or surrendering a life interest can trigger tax events that require careful structuring.
Given the complexity, it is important that life interests in property are established with legal and financial advice to avoid unintended tax consequences.
Life Interest vs Right to Reside
A life interest grants the life tenant the right to occupy, lease or sell a property for the duration of the interest. On the other hand, a right to reside only provides the right to occupy the property in accordance with the conditions set out in the Will.
Granting a right to reside is often employed to allow the spouse of a deceased to continue to reside at a property without triggering a capital gains tax event.
A common requirement in many Wills is that the person granted the right to reside must maintain and keep the property in a reasonable state of repair. If this requirement is not satisfied, the right to reside could be contested.
A right to reside will cease once the person granted that right no longer occupies the property. This may occur due to the person electing to forfeit their right to reside, or in the event the person granted the right to reside passes away.
In determining whether a life interest in a property has been granted as opposed to a right to reside, the Last Will and Testament (“Will”) of the deceased person must be considered.
When describing the interest in a property, a Will that uses words like “to permit to reside”, indicates a right to reside has been granted. A Will that uses words like “use and occupy” or “occupy” alone indicates a life interest in a property has been granted.
The distinction between the two rights is important and can have a major impact on how property is handled in bankruptcy.
How a Life Interest in Property is Handled in Bankruptcy
Life interests in property can hold substantial value. How the life interest is dealt with depends on your interest in the property:
If a deceased estate is insolvent, creditors may appoint an Administrator under Part XI of the Bankruptcy Act.
Where this occurs, a life interest satisfies the definition of “property” and vests in the Bankruptcy Trustee. The Bankruptcy Trustee has the option of:
- Evicting the life tenant to lease the property and collect rental income; or
- Evicting the life tenant to sell the property; or
- Negotiating a lump sum payment with the remainderman for the value of the life interest.
The “remainderman” is the person who is entitled to inherit the property once the life interest ends. If the Trustee chooses to negotiate, the remainderman can pay a lump sum that is equivalent to the value of the life interest, to a maximum of 20 years.
In this case, the property can then be sold by the Bankruptcy Trustee. The Trustee and the remainderman each collect a portion of the sale proceeds.
If a life tenant is bankrupt, their life interest vests in the Bankruptcy Trustee. The Trustee has the option of realising life interest for the benefit of the creditors. This usually involves selling the life interest to the remainderman.
See the case study below for a real life scenario the team at SV Partners encountered.
If the remainderman is bankrupt, their interest in a property that’s subject to a life interest vests in the Bankruptcy Trustee. As above, the Trustee may sell the interest for the benefit of the creditors.
Case Study
SV Partners were appointed Trustees of a bankrupt estate. The Bankrupt’s father was elderly and prior to the bankruptcy intended to leave the Bankrupt an interest in real property.
Upon the bankruptcy commencing, the Bankrupt’s father amended his Will to no longer leave an interest in the property to the Bankrupt. The father’s intention was to avoid the property vesting in the Bankruptcy Trustees and being realised for the benefit of creditors of the bankrupt estate.
Instead, the father left the Bankrupt a life interest in the property. During the period of the bankruptcy, the Bankrupt’s father passed away, leaving the Bankruptcy Trustees to consider their ability to realise the life interest in the property.
The Bankruptcy Trustees engaged an expert Valuer to obtain a valuation of the life interest in the property. This valuation was used as a tool to enter negotiations with the remainderman and the executor of the deceased estate to agree to a settlement for the return of the life interest to the deceased estate.
After agreeing to a settlement and entering into a Deed of Settlement, the Bankruptcy Trustees allowed the property to be sold with a portion of the sale proceeds collected by the Bankruptcy Trustees as payment of the settlement.
Realising the life interest allowed for sufficient recoveries to be made in the bankrupt estate to pay a dividend to creditors. If the Bankruptcy Trustees had not reviewed the Bankrupt’s Father’s Will and identified the life interest, it is unlikely any return would have been paid to creditors of the bankrupt estate.
Learn More About Life Interests in Property
As we said earlier, a life interest in property isn’t something you’re likely to encounter very often. But when you do, it helps to have the right team by your side, ready to guide you through. Contact us now for an obligation free consultation to get the expert advice you need.