Definition and Example of the Three-Year Rule
According to Section 2035 of the Internal Revenue Code (IRC), when you transfer ownership of any property to another person within three years of your death, it will still be included in the value of your estate. This rule presumes that it would have been included in the value of your estate in the first place, assuming you hadn't given it away and moved it out of your ownership.
The value is the asset's fair market value as of the date of death, not necessarily what you paid for it.
Taxpayers most commonly run afoul of this rule when they transfer ownership of a life insurance policy into an irrevocable life insurance trust (ILIT) that's been specifically formed to accept life insurance proceeds after their death.
Assets held in an irrevocable trust are normally exempt from estate taxes because ownership is legally moved from the individual to the trust. It can't be reversed or revoked. However, the assets in the trust are not exempt unless ownership of the policy was transferred more than three years before the person's death. If they were transferred within those three years, then Section 2035 of the IRC causes the life insurance proceeds to be included in the value of the estate for tax purposes.
What About the Estate Tax Exemption?
The federal gift tax goes hand in hand with the federal estate tax. They share a single lifetime exemption of $11.7 million for 2021 and $12.06 million for 2022. So long as the total combined amount of your estate and lifetime gifts does not exceed the lifetime exemption for the year in which you die, you do not have to file an estate tax return.
The value of your lifetime gifts is the total of all gifts which:
- Exceeded the small annual gift tax exclusion
- You didn't pay the gift tax at the time you made them
For 2021, the exclusion is up to $15,000 per person per year. That amount rises to $16,600 for 2022. The value of your taxable estate is what's left after subtracting any liens against the property.
For example, for 2022, if the total of your lifetime gifts and your gross estate was $5 million, you would not owe the estate tax because that amount does not exceed $12.06 million. However, if the total came to $12.36 million, you'd owe taxes on $300,000—the difference after deducting the $12.06 million lifetime exemption. The taxable amount of your estate that exceeds the exemption amount is taxed at a rate of 40%.
The Tax Cuts and Jobs Act (TCJA) increased the lifetime exemption in 2018 to $11.18 million from $5.49 million in 2017. It is set to drop back down (with inflation adjustments) if the TCJA expires as planned at the end of 2025.
How the Three-Year Rule Works
Section 2035 (b) of the IRC provides that "the amount of the gross estate…shall be increased by the amount of any tax paid…by the decedent or his estate on any gift made by the decedent or his spouse during the three-year period ending on the date of the decedent's death." This portion of the rule effectively reverses or negates the effect of the lifetime exemption on transfers of property (including cash gifts) within this three-year period. It ensures that the value of the gifts is included in the exemption calculation.
Gifts are exempt from the three-year rule if you did not have to file a gift tax return to claim the annual exclusion or did not have to pay the tax on the gift at the time you made it. However, this doesn't include life insurance policies. The three-year rule would still apply in the case of a policy gifted to an irrevocable life insurance trust.
Exceptions and Alternatives to the Three-Year Rule
You may be able to get around the three-year rule in the case of life insurance proceeds by reversing the order of the policy transfer. Rather than buying the policy, forming the trust, and then transferring the policy into the name of the trust, you could form the irrevocable trust first and then have it purchase the policy on your life.
This way, you are never the owner of the policy, so it's totally irrelevant to the value of your estate regardless of your date of death. The same exception applies if you're the insured, but you never owned the policy on your own life because another person owns the policy.
Joint policies, such as those that cover both spouses, may also help you get around the three-year rule. Only one spouse on the joint policy must outlive the three-year rule to avoid the proceeds from being included in the value of the estate.
The three-year rule also doesn't apply if you sell the policy to the ILIT. The keyword in this tax rule is "gratuitously." You can't give the policy away, but you can sell it—or any other asset—within three years of your death without adding its value to your estate. Section 2035 (d) of the tax code explicitly provides an exception for the "bona fide sale for an adequate and full consideration" of any asset. For example, you can't sell something for $1 when it's worth $1 million to escape the rule. You must sell the asset for its full fair market value.
- The three-year rule provides that you must outlive any "gratuitous" transfer of your property by at least three years to avoid it being included in the value of your estate for estate tax purposes.
- You can sell your assets for full fair market value, but you can't give them as a gift within three years of your death.
- This rule commonly comes into play when life insurance policies are transferred into the name of an irrevocable trust after the policyholder dies.