A Complete Guide to the Income and Estate Tax and Medicaid Implications of Gifting Assets

Cushing & Dolan, P.C.

Attorneys at Law

375 Totten Pond Road, Suite 200

Waltham, MA  02451

Tel:  617-523-1555

Fax:  617-523-5653

www.cushingdolan.com

tlutsky@cushingdolan.com

By

 Todd E. Lutsky, Esq., LL.M

 

I.   Introduction & Overview

a)     On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Authorization and Jobs Creation Act of 2010, known as the “2010 Act.”

b)    The 2010 Act increased and extended the federal estate and GST tax exemptions for two years, 2011 and 2012, and for the first time increased the federal gift tax exemption to $5,000,000 per person.

c)     At the end of 2012 President Obama singed legislation that set the Federal estate tax exemption and the GST tax exemption at 5,250,000 for the 2013 year and indexed it for inflation going forward.  He also increased the federal gift tax exemption by the same amount per person.

d)    The gift estate tax exemptions were indexed for inflation so that, in 2012, the exemption is $5,120,000 per person and now in 2013 these gift exemptions are at 5,250,000 tied to the estate tax exemptions.

e)     The following chart shows the federal and state estate and gift GST tax exemptions for 2003 to 2013.

 

Year

 

MA Exemption

Federal Estate & GST Tax Exemption

Federal Gift & GST Tax Exemption

2003

$700,000

$1 million

$1 million

2004

$850,000

$1.5 million

$1 million

2005

$950,000

$1.5 million

$1 million

2006

$1 million

$2 million

$1 million

2007

$1 million

$2 million

$1 million

2008

$1 million

$2 million

$1 million

2009

$1 million

$3.5 million

$1 million

2010

$1 million

No Federal Estate Tax

$1 million

2011

$1 million

$5 million

$5 million

2012

$1 million

$5.12 million*

$5.12 million*

2013

$1 million

$5.25 million

$5.25 million

NOTE: Massachusetts does not have a gift tax

*as indexed for inflation beginning in 2012

 

PLANNING NOTE:

Prior to the year 2010 the gift tax exemption was stuck at $1,000,000 while the estate tax exemption was increasing.  This was designed to prevent folks from making large lifetime gifts without paying gift tax.  However, the government has given the taxpayers a gift by increasing the gift tax exemption to currently $5,250,000 per person.  This means that each taxpayer can gift up to $5,250,000 worth away without paying any gift tax.  It is very important to meet with your estate planning attorney and explore the benefits and potential tax traps associated with taking advantage of what may appear to be a gift giving bonanza.

 

Gift Giving Tax Considerations:  The Basis Rules

a)     Compare the tax consequences of a step-up in basis attributable to inherited property vs. carryover basis in the case of lifetime gifts.

(1)    Basis of property acquired from the decedent.

A. IRC § 1014 provides:

“Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passes from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person be – (1) the fair market value of the property on the date of the decedent’s death.”  IRC § 1014(a)(1)

B. IRC § 1014(b) provides:

“For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent:

  1. Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent;  IRC § 1014(b)(1)
  2. Property transferred by the decedent during his lifetime in trust to pay the income for life to or on the order or direction of the decedent, with the right reserved to the decedent at all times before his death to revoke the trust;”  IRC § 1014(b)(2)
  3. “Property passing without full and adequate consideration under a general power of appointment exercised by the decedent by will;”  IRC § 1014(b)(4)
  4. “In the case of decedents dying after December 31, 1953, property acquired from the decedent by reason of death, form of ownership, or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof the property is required to be included in determining the value of the decedent’s gross estate.”  IRC § 1014(b)(9)
  5. “Property includible in the gross estate of the decedent under section 2044 (relating to certain property for which marital deduction was previously allowed).” IRC § 1014(b)(10)

 

PLANNING NOTE:  

The above regulation simply explains that if you die owning assets that have appreciated in value then the people you leave the assets to will get the asset with a new cost basis equal to fair market value.  This means that if the beneficiaries sell the asset shortly after you die they will not have to pay any capital gains taxes.  It is also very important to remember that when considering gifting to make sure you do not give it directly to your children or other family members as this will cause the assets to be exposed to their creditors and future divorces etc.  In addition any such outright gift would result in your complete loss of control of the assets.  When making gifts please consider the use of an irrevocable trust to hold the assets for the benefit of the children or other family members at least until your passing in order to prevent having the assets exposed to their creditors.

C. Exception:

IRC § 1014(e) prohibits a step-up acquired from a decedent if appreciated property was acquired by the decedent by gift during the one year period ending on the date of the decedent’s death and such property is acquired from the decedent (or passes from the decedent to) the donor of such property (or the spouse of such donor).  In such a case, the basis of such property in the hands of the donor or donor’s spouse shall be the adjusted basis of such property in the hands of the decedent immediately before the death of the decedent.  IRC § 1014(e)(1)

(2)    Holding Period (When is the gain on this type of property considered long term gain)

A. Inherited Property

In the case of property acquired from a decedent (within the meaning of IRC § 1014(b), if the basis of such property in the hands of the person is determined under IRC § 1014 and such property is sold or otherwise disposed of by such person within one year after the decedent’s death, then such person shall be considered to have held such property for more than one year.  IRC § 1223 (9)

B. Gifted Property

In determining the holding period of property which has been acquired by gift, the holding period of the grantor will be added to the holding period of the donee for purpose of determining gain or loss from the seller exchange to the extent the donee was required to use the donor’s basis as his basis.  IRC § 1223 (2)

 

PLANNING NOTE

The importance of the holding period is to determine if the gain associated with the assets sold will be treated as long term capital gain or short term capital gain.  If you inherit the property from a decedent and get a step up in basis and sell it shortly after getting it you will be able to treat that gain if any as long term capital gain.  Generally you have to hold the asset for more than 12 months in order to get this long term gain treatment but this is an exception to this rule.  Remember it is always better to get long term gain treatment as the tax rates are currently only 20% federally, (note potential net investment income tax of 3.8% may apply under Obama care act on net investment income over $250,000). If the fair market value at the time of the gift is used as the donee’s basis, such as when property is sold for a loss, the holding period starts the date after the gift is made.  IRS Publication 544.

Does property have to be inherited in order to obtain a step-up in basis?

Generally, yes, but there are certain exceptions when property was given away during life and the decedent either retained a life interest or a life estate or merely continued to use the property without paying rent.  IRC ‘ 2036(a)(1) requires that the fair market value of the property be includible in the decedents estate for estate tax purposes, even though the property would not be includible for probate purposes.  This can actually provide a benefit as long as the value of the property included in the decedent’s estate does not exceed either the Massachusetts or federal estate tax thresholds.

In Rev. Rul. 70-155 and Estate of Guynn, 437 F.2d 1148 (4th Cir. 1971), it was ruled that the transfer by the decedent of property before death was includible in the decedent’s estate for estate tax purposes if the donor continued to use the property before death and did not pay fair rent.  On the theory that there was an implied life estate.

This theory has been followed recently in the Estate of Maxwell, 98 T.C. 39 (1992) in which the decedent had sold property to his children before death and had received approximately 50% of the sale proceeds, but continued to live in the property after the purported sale.  The decedent’s will forgave the note at death and the decedent was canceling $20,000 of the note each year.  The Tax Court ruled that the full fair market value of the property was includible and that the sale transaction should be ignored under IRC ‘ 2036 using an implied life estate theory.  This retained life estate may be avoided if the decedent owned property as a tenant in common with his children within the theory of Estate of Powell v. Commissioner, 63 T.C.M. 3192 (1992).  See also, Estate of Wineman, 79 T.C.M. 2189 (2000).

These rules can provide potentially good news to heirs who are selling property after the donor died, but where the property was gifted before death.  Usually, the donee’s basis is equal to the donor’s basis, increased by any gift taxes paid under IRC ‘ 1015.

From a Medicaid perspective the fact that the property has in fact been gifted away would have started the five year clock for nursing home protection purposes.  In effect this property would have ultimately been protected from the nursing home but at the risk of the children’s creditors and complete loss of control by the parent during the parents life along with the potential risk of the loss in this step up in basis if the person preparing your tax return does not know about these case exceptions. Remember the best planning is advanced planning using Medicaid irrevocable trusts and not to just gift away your home or vacation home to your children prior to your death.

How do you determine the basis of property inherited by a surviving spouse rather than children? 

This depends upon how the property was owned on the date of death, but in the case of jointly owned property, if the property was acquired after 1977, one-half of the fair market value of the property is includible in the estate of the first spouse to die so that the surviving spouse would receive a partial step-up equal to that amount includible in the estate of the first spouse to die.  This would then be added to one-half of the original cost to determine the surviving spouse’s basis.  There is a special rule, however, which may be applied in the case of property acquired by a couple before 1976.

If the property was acquired before 1977 and is held jointly on the date of the death of the first spouse to die, the full fair market value of the property would be includible in the estate of the first spouse so that the surviving spouse would acquire a full step-up in basis.  Gallenstein v. United States, 91-2 U.S.T.C. &60,088 (ED KY 1991), affd 975 F.2d 286 (6th Cir. 1992).  See also, Patten, 96-1 U.S.T.C. &60,231 (DC CA 1996) and Anderson, 96-2 U.S.T.C. &60,235 (DC MD 1996).  In both of these cases, the estate tax return was filed incorrectly, but the Tax Court ruled that the amount reported on the decedent’s estate tax return was not determinative of basis, rather, basis is equal to the amount that should have been includible had the estate tax return been filed properly, and there was no need to amend the estate tax return to get this full step up in basis.

For state estate tax purposes you must consult with an estate tax attorney in your state as the basis rule can vary by state.  However, in Massachusetts, if the property that was joint with the deceased spouse is sold by the surviving spouse after January 1, 1997 then the basis for capital gains tax purposes will follow the federal rules and would have received a full step up in basis on the death of the first spouse to die.  If the surviving spouse sold the property prior to January 1, 1997 then the basis is the hand of the surviving spouse as to the property that was held jointly by the deceased spouse will be have received only a one half step up in basis.  This could result in some capital gain on the sale of the property.

EXAMPLE #1 (potential pitfalls of gifting appreciated assets)
  • Assume single decedent with $5,000,000 in zero basis assets and is considering an irrevocable gift in 2013. Prior to gifting always consider the type of asset that you are gifting.
  • Assume also that property will be sold shortly after death at a price equal to the fair market value on the date of death.  Assume a combined capital tax rate of 28.8% (20% federal; 5% state 3.8% Obama care tax on net investment income over $250,000)

 

NO GIFT                                     GIFT

FMV                                       $5,000,000                              $5,000,000
BASIS                                                         0                                                   0
SALE AFTER DEATH

SALE PRICE                          $5,000,000                              $5,000,000
BASIS (step up)                     $5,000,000    (no step up)   $                  0
GAIN                                        $                  0                              $5,000,000
TAX 28.8%                             $                  0                              $1,440,000
FEDERAL ESTATE TAX     $                 0                             $                  0
STATE ESTATE TAX            $   391,600                              $                 0
INCOME TAX                        $                 0                             $1,440,000
TOTAL TAXES                      $   391,600                              $1,440,000

 

Gift is a bad idea!  Sometimes paying state estate tax is better than paying capital gains tax.

Planning Pointer:  This demonstrates what can happen if you gift assets that have a very low basis, which means there is a large amount of built in capital gain which will have to be paid when the beneficiary sells the assets.  In essence, if the wrong assets are given away your beneficiaries may end up paying more in capital gains taxes than your estate would have paid in estate taxes. Whereas if these assets were retained until the death of the individual then the basis would equal the fair market value, as explained above, thus eliminating the capital gains tax liability if the assets are sold shortly after your death.  It is however, important to balance the potential estate tax consequences of retaining the assets till you death verses gifting them away while your are still living.  Remember, any assets you retain are included in your estate at death and subject to estate tax.

Gifting While Retaining the Enjoyment of the Assets
Through the Use of an Irrevocable Spousal Lifetime Access Trusts

For folks with assets well over the $2,000,0000 range you may want to consider irrevocable spousal lifetime access trusts. In order to make a completed gift that will remove the asset from your gross estate upon your demise the giver must not retain any ability to enjoy or control the assets given away.  In the event such control or beneficial ownership is retained at the death of the giver the assets will be pulled back into the estate of that person and subject to estate taxes.  This is the rule that generally makes people have second thoughts about gifting as many folks are always concerned about making sure they have enough assets to live on the rest of their lives. The solution is these irrevocable spousal lifetime access trusts.

In this regard, husband and wife have the ability to set up irrevocable trusts for the benefit of the other provided the trusts do not have exactly the same terms and conditions.  For Example, husband creates an irrevocable grantor trust and names his wife as the trustee.  Husband will then gift assets to this trust but will not retain the right to control them as he is not the trustee nor will he have the ability to get the income or principal back from the trust.  He will have effectively given these assets completely away and upon his demise all the trust assets along with any growth of such assets will be outside of his estate for estate tax purposes. Also since the asset are in the trust and not owned by the children they are not exposed to the children’s creditors.  However, husband can retain the right to remove and replace the trustee provide however that the replacement trustee is not him or anyone related or subordinate to him.

However, this irrevocable trust can provide that the wife as initial trustee can manage and invest the assets as well as receive all the income that the trust generates. Since these trusts are grantor trusts the trust income will be taxed to the husband at their own rates rather than the higher trust tax rates.  In addition, she is entitled to the principal from the trust as needed to for her health, education, maintenance and support.  In other words these assets are left in trust but really for her benefit.  Since she did not gift any of the assets to this trust when she passes away none of these assets will be included in her estate either and instead will pass estate tax free to the family.  Meanwhile, the wife can create her own trust that essentially does the same thing but allows husband access to the assets and effectively both of these trusts will pass assets and all of the related growth free of estate taxes to the family following their demise.  In essence assets can be gifted while indirectly enjoying what was given away to ensure that you can continue to live comfortable the rest of your lives.  Remember these trusts cannot be exactly the same and a complete explanation of these trusts is beyond the scope of this article but to learn more please contact Todd E. Lutsky Esq. LL.M at 617-523-1555.

In the event you are single then you can create an irrevocable trust of which you cannot serve as trustee and gift assets to it but retain or purchase a private annuity from the trust.   You would enter into an agreement with the trustee to have the trust pay you a fixed percentage amount from the trust each year on a monthly basis for the rest of your life.  For example, if you transfer to the trust $2,000,000 you may wish to be paid 5% back each year.  The trust under the private annuity agreement will be obligated to pay you this much money each year from the trust even if the trust does not generate this much income.  Upon your demise the annuity ends and none of the trust assets are included in your estate for estate tax purposes.  This is a way for single people to give away assets while still ensuring they can live the rest of their lives.  Finally, the trust will be a grantor trust so the purchase of the annuity is a non taxable event and all the income generated from the trust will be paid on your personal return so as not to incur a higher tax rate for the trust.  The trust will also allow a distribution to be made to you for the taxes paid in the event you do not wish to pay the taxes on the income earned on the assets inside the trust.  Again a complete discussion on these types of gifting trusts coupled with private annuities is beyond the scope of this article but to learn more please contact Todd E, Lutsky Esq. LL.M at 617-523-1555.

 

Other Aspects of Gifting, Forms of Ownership and Related Tax, Control and Medicaid Issues

Joint Accounts from Bank to Brokerage Accounts for Married Couples:

  • All accounts of married couples whether they be bank or investment accounts are all considered countable in their entirety for nursing home purposes.

This form of ownership however,  may result in the payment of unnecessary Federal and State taxes via the unlimited marital deduction thus wasting the first spouse’s exemption amount.  This exemption amount is the amount of assets a spouse can pass to the next generation without paying any estate tax.  This amount is currently $5,250,000 at the Federal level and $1,000,000 here in Massachusetts.  While a complete discussion of estate planning is beyond the scope of this article, suffice it to say that through the use of revocable or irrevocable trusts, instead of joint ownership a couple can double the above amounts thus leaving that amount to the family estate tax free.

  • There would be no gift tax associated with this form of joint ownership as married couples are permitted to make unlimited gifts to each other via the unlimited marital deduction. However such gifts generally do not accomplish any estate tax savings or nursing home protection.
  • This form of ownership would result in only a one half step up in basis for capital gains tax purposes, as mentioned above.  This is because upon the death of a spouse only one half the values of the jointly held assets are included in the estate of the deceased spouse.  The result of this is to eliminate only one half of the gain that may have been built up on the assets in the joint account. 

Joint Investment Accounts for Single People:

  • Any asset, other than a joint bank account, jointly owned by two or more individuals, for example an investment account joint with a child, is presumed to be owned in equal shares and counted proportionately for Medicaid purposes, unless a different distribution of ownership is verified.

Planning Pointer:

  • If you have a joint investment account with a child, then one half of the investment account would not be at risk upon admission to the nursing home and that child could take half the account without a five year waiting period being applied.  Caution, this account could not be set up right before applying for Medicaid plus there are other loss of control and creditor issues that one should be concerned about when owning assets jointly with a not spouse.

Joint Bank Accounts if Single:

  • When the applicant or member is a joint owner of a bank account with a child, the entire amount on deposit is considered available to the applicant for Medicaid eligibility purposes.  If the applicant claims partial ownership of the funds he or she must verify the amount owned by each joint depositor.  When such a partial ownership is verified, then only that portion of the assets is considered countable for nursing home purposes.

Joint Bank or Investment Accounts in General for Single people:  (Are such accounts completed gifts

  • There is no gift tax due upon the establishment of a joint account but the moment the non-contributing joint owner withdraws all the money a completed gift takes place and may result in a gift tax liability if the amount gifted exceeds the allowable $14,000 limit per year per person.   This is known as the present interest exclusion as is in addition to the gift tax exemptions mentioned above.  This is the amount that you may give away per person per year without triggering a gift tax liability.   In addition, if the amount is over this limit then a gift tax return must be filed.   A complete discussion of the gift tax rules is beyond the scope of this article.
  • This form of ownership exposes the assets in the accounts to the creditors of the joint owner at least up to one half the value of the account.  For example, if your child is placed on the account and then experiences financial difficulties or a divorce then one half of all these joint assets will be at risk to those creditors.
  • This form of ownership also results in a loss of control over the assets as the non-contributing joint owner can go and take out all of the assets anytime he or she desires.

Planning Pointer:  (capital gains tax and basis issues and disinheritance issues with these joint accounts)

If,  for example,  you put one child’s name on numerous accounts, since that child is located nearby and maybe taking care of you and paying all the bills, then upon your passing those assets would go to that child only and to the exclusion of all other children which may not be your intention.

  • This form of ownership would at least provide the surviving joint owner with a full step up in basis in the assets received provided the surviving joint owner did not contribute any of the assets to the account.  The assumption is that the full value of jointly owned assets with a non spouse will be included in the estate of the deceased joint owner unless contribution is shown by the surviving joint owner.  This means that if the assets in the account, say stocks and mutual funds, had grown in value over the years then all of that appreciation built up will be eliminated upon death of the contributing joint owner as the cost basis to the surviving owner will be increased to equal the new fair market value as of the date of death.  Therefore, if the assets in such account are sold shortly after the death of the contributing joint owner there would little or no capital gains tax to be paid.  

Outright Gifts of Bank or Brokerage Accounts to Family Members and Related Tax and other Consequences:

  • Gifts of assets result in complete loss of control by the person who made the gift as the assets are not theirs any more. Once they are given away you would have to ask the permission of the person you gave the assets to every time you wanted to access them or use them in any way.  The last thing this author wants is for the parents to have to ask permission from their children for anything.
  • Gifts of assets will expose the entire asset to the creditors of the person to whom the gift was madeFor example:   if you give an asset to your child and that child has a financial problem or a divorce then the asset gifted is at risk for that child’s creditor.  Therefore, even though you trust your children, problems can happen beyond their control and exposing such assets to their creditors is not good for them or for you.
  • This type of gift could also result in adverse gift tax consequences to the giver.  If the amount gifted exceeds the $14,000 amount mentioned above then a gift tax return must be filed and this may result in a gift tax to the giver.  Remember, there is never a gift tax to the person who receives the gift.
  • Unlike the joint ownership, outright gifts result in a carryover of cost basis in the asset gifted which may result in an adverse and oftentimes completely unnecessary capital gains tax to be paid by the recipient of the gift
  • For Exampleif you gifted a stock portfolio that you paid $100,000 for all the assets in it and on the date of gift the value of the portfolio is worth $200,000 then the built in gain is $100,000.  If gifted away then the recipient of the gift will have to pay the capital gains tax on that amount which assuming a 20% federal and 5% state capital gains tax rate is approximately $25,000.  If proper planning is done and the person dies owning these assets then this gain would be eliminated due to the step up in cost basis discussed above.
  • I guess if you can stomach all of the above negatives that go along with outright gifting of your assets to family members at least you can take away the fact that such asset will be protected from the costs of long term care five years following the date of the gift.
  • Instead, you may want to consider gifting to an irrevocable Medicaid trust that will enable you to retain some control, protect it from the kids creditors, protect it from the cost of long term care while eliminating these capital gains tax consequences.

 

Primary Residence of  a Married Couple:   The Medicaid Perspective:

  • Provided a spouse is living in the home it will be considered non-countable and a lien cannot  be placed on it.  It is very important not to leave the home in joint names after one spouse is institutionalized as this will put the home at risk in the event the healthy spouse dies prior to the sick spouse.  Finally, it is important to plan to protect the home after the sick spouse has been approved for Medicaid as the home will remain at risk if the healthy spouse were to need nursing home care in the future, consider the use of an irrevocable trust to protect the home.

Primary Residence of a Single Person:  The Medicaid Perspective:

  • The home is considered non-countable for Medicaid purposes as long as the applicant checks a box on the Medicaid application indicating that he or she intends to return home even if not likely to happen.
  • However, the state will be able to place a lien on the property once they determine that there is no reasonable expectation that the applicant will return home.  This means that the state will be able to pursue the property following your demise in an effort to recover some of the benefits that the applicant received during life.  This is known as estate recovery.  In other words, while the home may not at risk for the nursing home currently, it ultimately will be without proper advanced planning.

Planning Pointer:

  • Always remember, once on Medicaid the rate paid to the nursing home is about half what would be paid privately, therefore, the lien will be much smaller  thereby increasing the chance of saving the home.

Vacation and Rental Properties for Married and Single People:  The Medicaid Perspective:

  • Any Real Estate owned which is not your primary residence is considered countable assets and will prevent the institutionalized individual from becoming eligible for Medicaid benefits.  Typically the State will place a lien on these properties and then force you to sell them and to use the proceeds to pay for your nursing home care.  This is why advanced planning through the use of irrevocable trusts is essential in order to save the family vacation and/or rental properties.

Planning Pointer:

  •  Even if no advanced planning was done, you can still try to rent out the vacation home (and of course the rental property is already rented out) as long as it is generating income essential to self-support, the State will allow you to keep the property and deem it to be non-countable for Medicaid eligibility purposes.  However, the State will place a lien on the property in case it is sold during life and it will be there so the State can recover the benefits paid out following the death of the applicant.  This is known as Estate Recovery.  Remember, the rent will be used to offset the Medicaid benefits thereby reducing the lien.  In addition, being on Medicaid is better than private paying since the Medicaid rate is around half the cost of private paying the nursing home which in turn helps to save these properties.

 

Estate, Gift and Income Taxes Associated with the Primary Residence, Vacation and Rental properties and Various Forms of Ownership:

Joint  tenants by the entirety:

  • Let’s begin with the home, which is currently owned as joint tenants by the entirety between say John and Mary.  It is important to note that this form of ownership can only be used between spouses and only with regard to their primary residence.  From a creditor standpoint, this form of ownership is beneficial in that the creditor cannot force half of the property to be sold in order to satisfy the outstanding obligation against either spouse individually.  Say, for example, one spouse was sued personally with regard to his business, which had nothing to do with the other spouse, the creditor would not be able to force either spouse to sell the home in order to access half of the equity.  All the following issues apply to the property if it was owned jointly with rights of survivorship except for the creditor protection mentioned above.
  • With regard to estate tax planning, this form of ownership would waste the first spouse’s exemption amount as all the jointly owned property, including bank and investment accounts, would pass under the unlimited marital deduction to the surviving spouse thus subjecting it to estate taxes upon the death of the surviving spouse.  As mentioned above, the marital deduction allows a spouse to leave an unlimited amount of assets to the surviving spouse without ever paying any estate taxes, but would effectively waste the spouses’ ability to utilize their current Federal and State estate tax exemption amounts, generally resulting in a larger estate tax due upon the death of the surviving spouse.
  • There is however a currently portability rule in place for the Federal exemption but should not be relied on for a whole host of reasons the biggest of which is that it is not automatic and requires the filing of an estate tax return to elect portability, the future growth of the assets are not estate tax free and Massachusetts exemption is not portable. A complete discussion of this rule is beyond the scope of this article.

Therefore, the suggested form of ownership for John and Mary’s home would be to have it transferred from John and Mary as joint owners directly to John and Mary as trustees of their joint family revocable trust.  This form of ownership works well for the moderate estate valued at less than $2,000,000.  For estates larger than that, then the property should be transferred to John and Mary as trustees of a nominee realty trust  with their respective family revocable trusts serving as 50% beneficial owners. If they were also interested in nursing home protection then they should consider the use of irrevocable Medicaid trusts instead of revocable trusts. These revocable trust arrangements would allow them to remain in complete control of their home during their lives, avoid the costs associated with the probate process and ultimately help them utilize both their Federal and State estate tax exemption equivalent amounts, thereby reducing and possibly (eliminating) their estate tax exposure.  The irrevocable trusts do all the same things but add the nursing home protection component while still ensuring that they retain a significant degree of control over the trust assets.  A complete discussion of revocable and irrevocable trusts and estate taxes are beyond the scope of this article, but to learn more about these topics you can call

Todd E. Lutsky Esq. LL.M at (617) 523-1555 for an initial consultation.

With regard to gift taxes, there is no gift tax consequences associated with spouses owning real estate jointly as spouses are permitted to make gifts to one another in an unlimited manner through the unlimited marital deduction mentioned above.  There is also no gift tax consequences associated with transferring the real estate to either the revocable or irrevocable trusts mentioned above.

Owning assets jointly between spouses would result in only a one half step up in basis for capital gains tax purposes.  This is because upon the death of a spouse only one half the values of the jointly held assets are included in the estate of the deceased spouse.  The result of this is to eliminate only one half of the gain that may have been built up on the assets in the joint account which maybe significant considering how long ago the home or other real estate may have been purchased.  A step up in basis  means that the surviving spouse would get the fair market value of the asset as of the date of death but in this case the spouse would only get one half of that value thus leaving  some gain built in and potentially subject to tax when it is sold.

 

To Gift or Not to Gift:  The Home, Vacation or Rental Properties or

Simply To Add a Child’s Name to Such Real Estate:

Give It Away:  John and Mary then considered giving their home to their children during their lives.  Gifting the home or any highly appreciated piece of property like brokerage accounts mentioned above, to the children is not generally considered a recommended option in terms of real estate ownership, as it is fraught with problems.  First, John and Mary would have lost complete control over any such real estate during their lives and with regard to their home, if they did not retain a life estate, they would have lost even the right to live there for the balance of their lives.  Furthermore, if they gifted the entire property they would have lost the ability to sell any such property or use the proceeds, while strapping their children with negative capital gains tax consequences due to the carry over basis they would have received instead of the step up in basis, discussed above.  This gifting idea would have also resulted in John and Mary loosing their capital gains tax exclusion associated with the sale of their primary residence.  Finally, this form of ownership would expose the asset to their children’s creditors such as divorces and financial difficulties while they are still alive which could certainly adversely affect John and Mary.

Life Estates:  This is when a person transfers the remainder interest in their home either to family members or an irrevocable trust and retains the right to live there for the rest of their life.  This will protect the home from the nursing home five years after the date of transfer as well as ensure a full step up in basis for capital gains tax purposes upon the death of the life tenant, but if given to the kids will result in a loss of control, difficulty in selling it later, greater exposure to children’s creditors, inability to change beneficiaries later and adverse income and gift tax consequences.  For example, if the property in a life estate arrangement were to be sold the John and Mary would need the kids permission, only a small portion of the proceeds equal to the life tenants interest would flow to John and Mary and they would have very little money to buy another home.  In addition, the kids as remainder beneficiaries would get a larger portion of the money and that would be subject to capital gains tax unless the kids lived in the home as their primary residence which is generally not the case. While these adverse control and tax consequences can be avoided if the remainder interest is given to the irrevocable trust, the use of life estates are generally limited to people who may need a reverse mortgage in the future and short of that, are not the most favored form of asset protection.

In this regard, while the gift of any highly appreciated property may result in a gift tax to the giver, it does not result in any immediate tax consequences to the recipient, but the recipient would receive a carryover basis from the giver.  In other words, if John and Mary’s entire cost basis for their home, including all capital improvements made over their lifetime is $100,000, the children would receive that same cost basis, thereby trapping any capital gain that is currently built into their residence.  Just a reminder, this same capital gains tax problem exists when you gift highly appreciated stocks as well.

For example, assuming John and Mary gave their home to the children and upon their demise, the home was worth approximately $500,000, and the children decide to sell it, they would have to recognize a $400,000 capital gain on their individual income tax returns.  Assuming a 20% federal capital gains tax rate, a 5% tax rate at the State level and a 3.8% net investment income tax for Obama care tax that would result in a tax liability of approximately $115,200.  This assumes that the children do not live in the house so they would not be entitled to the capital gains tax exclusion of $500,000 if married and $250,000 if single for owning and using their primary residence for two of the last five years.  Remember if John and Mary kept their home and sold it during life they would have been able to avail themselves of this exclusion resulting in no capital gains tax upon the sale of their primary residence.  They also could have used the money to buy a new downsized place which is usually what happens as folks age.

In addition, John and Mary would have to consider the gift tax implications of giving their home away during life.  In this regard, they are currently limited to gifting $14,000 per year per person without incurring a gift tax consequence.  However, instead of paying any gift tax, they would be entitled to utilize a portion of their current $5,250,000 exemption amounts, which would simply result in their ability to shelter less assets from estate taxes upon their demise. Not sure this is a good trade off knowing the capital gains tax problems mentioned above due to the loss of the step up in cost basis. Remember, as mentioned above, it is important to balance the estate tax consequences with the capital gain tax consequences.  In addition, it is important to think about the loss of control and nursing home protection issues as well.

Instead, John and Mary should own their home in their respective revocable trusts as mentioned above.  These revocable trusts would allow them to sell their home at any time, and avoid any related negative capital gains tax consequences while at the same time better utilizing their Federal and State estate tax exemptions which allow them to each shelter currently up to $5,250,000 Federally and $2,000,000 Massachusetts estate tax free.  In this regard, if they have owned and used their property as their primary residence for two of the last five years and then sold it, they would be entitled to avail themselves of a $500,000 capital gains tax exclusion, thereby virtually eliminating any capital gains tax consequences associated with the sale.  Owning their home in revocable grantor trusts will not jeopardize this capital gains tax exclusion.  Finally, they could own their home in irrevocable Medicaid income only trusts and preserve all of these same estate and income tax benefits while protecting the assets from the nursing home, as explained in more detail below.

Furthermore, by having the revocable or the irrevocable trusts pass their home to their children following their demise, the children would receive what is known as a step-up in basis for capital gains tax purposes.  This means that the children’s cost basis in the home would be stepped-up to the fair market value of the home as of the date of John and Mary’s demise, thereby eliminating any capital gains tax consequences to the children in the event they sold the home shortly after their demise.  In other words, if the home had a fair market value of $500,000 on the date of John and Mary’s demise and the children sold it shortly thereafter, their basis would be $500,000 thereby eliminating any capital gain and saving the children approximately $115,200 in capital gains taxes.  In addition, the trust planning that they had in place could have completely eliminated or certainly reduced their federal and state estate tax exposure based on the size of their estate.

All of these same gift and income tax consequences exist with jointly owned rental or vacation properties between spouses except that the capital gains exclusion only exists only on the primary residence.

Finally, a large portion of these tax and control benefits can be obtained through the use of grantor irrevocable trusts while adding the benefit of protecting these assets from the costs of long term care, which the revocable trust does not offer.  Please contact Todd E. Lutsky Esq. LL.M at 617-523-1555 for more detailed information on the use and operation of these irrevocable Medicaid type trusts.

 

 Tax and other Issues Associated with Owning Rental, Vacation or Even the Primary Residence with Children or Others:

Another common mistake that occurs when dealing with real estate ownership is owning it either with a child or a friend as Tenants in Common.   Example:   John and Mary simply wanted to add all of their children’s names to one of their rental properties as a tenant in common.  As a result of this,  John and Mary will have significantly reduced their control over that piece of property for , if they ever wanted to sell it, they would now need their children’s permission.  In the event the children did agree to sell the real estate, John and Mary must remember that a portion of the proceeds would go to the children and not them.  This may be a problem, especially if John and Mary needed that money to enhance their retirement, or buy a replacement property.  In addition, even if the kids wanted to give back the proceeds they may be subject to a gift tax and would have to worry about the gift tax rules that were discussed above.  This is all on top of any capital gains tax that would have been paid by them from the sale of the property.

From a creditor standpoint, John and Mary have exposed this particular rental property to their children’s creditors.  In other words, in the event any one of their children were to have a car accident, financial difficulty or a divorce while John and Mary are living, then that particular piece of property would be exposed to those creditors.  John and Mary also consider the flip side of this equation, which is that, if a tenant gets hurt on the rental property and files a law suit, that such suit would still be against John and Mary individually, but would now include all of the children whose names appear on that particular deed as well as exposing all of their homes and other personal assets to that creditor.

John and Mary also considered the income tax consequences of such an arrangement.  In other words, once they add the children’s names to a rental property, they must also sacrifice a portion of the rent as such rent must be allocated among the owners equally and reported on their respective income tax returns.

Once John and Mary add either their children’s name or a friend’s name to any property, whether it is as joint tenants or as tenants in common, there always remains the possibility that any individual owner can petition the court to partition the property and force a sale of the property. They must also consider the fact that the mere addition of a name to real estate is a completed gift for gift tax purposes and will subject them to the gift tax rules mentioned above.  They also will have lost the ability to sell it without getting the permission from the children or other owner.  Also upon sale, half of the proceeds will go to the other owner and not to John and Mary who may need these funds to retire on or buy another home.  Finally, such an action will also expose one half of the property to the children or other owner’s financial creditors and or divorces, which certainly is not good for John and Mary and really not good for the kids either.  Finally, if you only put one child’s name on the deed then you may have inadvertently disinherited the other children (at least as to this asset) since it will pass outside of probate and directly to the surviving joint owner.

Furthermore, many time folks do not even realize they made a gift to the kids because they generally put property in a nominee realty trust and think the kids as beneficiaries will not get the property till they die.  However, these nominee realty trust operate to flow the property directly to the beneficiaries the moment they are created thus completing the gift as soon as the property is transferred to the realty trust.  This would mean that the kids would own it right away and if they get a divorce the parents would loose their home or other property in this trust.  Folks please look at your realty trusts if you have them and see who the beneficiaries are and if it is your children please contact your attorney and see how this can be fixed before something bad happens.

From a Medicaid perspective, this form ownership would only protect one half of the property from the cost of long term care.  Generally folks want the full amount of the asset protected.  In order to save this last minute the children may have to buy the other have of the property.

Irrevocable Income Only Trusts As A Gifting Alternative for Real Estate and Investments:

Modified Irrevocable Income Only Trusts:

These trusts remain the best form of advanced nursing home planning available.

These trusts allow the parent to:

  • Retain control over the trust assets by either being the trustee or retaining the right to remove the trustee any time for any reason, which for example, will enable you to sell your home and replace it without the children’s permission and without resetting the five year look back period.
  • The assets in the trusts are not at risk for the financial troubles mentioned earlier such as divorces of your children, simply because you did not give it to them yet.
  • Manage any and all other trust investments and collect all trust income.
  • Retain tax benefits such as maintaining the $250,000 or if married the $500,000 capital gains tax exclusions on the sale of your primary residence.  In addition, you will continue to pay income taxes at the same rates as you did prior to establishing the trust provided the trust is a grantor trust.
  • Your children will still get a full step up in basis upon the parents death which will eliminate capital gains tax consequences if the property is sold shortly after the parents death.
  • Retain the ability to change the beneficiaries of the trust later in life as life events tend to change over time.  For example, if later in life you wanted to leave more assets to the grandkids, you would be able to make that change to the trust without needing anyone’s permission.
  • There are no adverse gift tax consequences with the transferring assets to the irrevocable trust.
  • In fact, the trust really accomplishes your estate tax and even nursing home protection planning without any of the adverse gift, estate or income tax consequences, loss of control or creditor exposure issues that are associated with the gifting or joint ownership of assets discussed above.

Estate and Asset Protection Planning at the Same Time:

Finally, with the estate tax exemptions increased to $5,250,000 and indexed for inflation and the Massachusetts exemption amount at $1,000,000more and more married couples want to do both estate and asset protection planning at the same time. These irrevocable Medicaid trusts can do that by utilizing both exemption amounts at your death.  If you are married, your estate is $2,000,000 or less, you can create two of these trusts and split the assets between them, then upon your demise, the trust assets will avoid probate and will get to your family federal and Massachusetts estate tax free. In addition, five years after these trusts are funded with your assets they will also be protected from the nursing home and will avoid Medicaid estate recovery provisions upon your demise.  All this can be accomplished with little or no loss of control over the trust assets and as explained above without any adverse income tax consequences during your life.  A complete discussion of these irrevocable income only trusts are beyond the scope of this article but to learn more about them you can contact Todd E. Lutsky Esq. LL.M with the law firm of Cushing and Dolan at  (617)-523-1555.

SUMMARY:

  • Thoughtfully preparing legal documents that you will need allows you the opportunity for your wishes to be carried out.
  • Proper estate planning can limit expenses and provide your heirs with funds according to your wishes.
  • Properly established and funded Irrevocable trusts enhance privacy, provide your heirs with funds according to your wishes, protect assets from the nursing home, reduce estate taxes and avoid probate.
  • The next step is to take action.

 

Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors. Armstrong Advisory Group, Cushing & Dolan and The Securities America Companies are unaffiliated.  Representatives of Securities America Inc. do not provide legal or tax advice.  The scenarios provided are for illustrative purposes only and not intended to represent client experiences of Armstrong Advisory Group or the Securities America companies.  Please consult with a local attorney or tax advisor who is familiar with the particular laws of your state.  December 2013 – 756437