An Operational Guide to Life Estates vs. Irrevocable Trusts
How Would You Rather Protect Your Home From A Nursing Home?
TODD E. LUTSKY, ESQ., LL.M
Cushing & Dolan, P.C.
Attorneys at Law
Totten Pond Road Office Park
375 Totten Pond Road, Suite 200
Waltham, MA 02451
Telephone: (617) 523-1555
Fax: (617) 523-5653
What is a Life Estate?
A life estate is not a Trust according to the MassHealth regulations. A Life Estate is established when all of the remainder legal interest in a property is transferred to another, while the legal interest for life, right to use, occupy or obtain income from the property is retained. For example, in the event a husband and wife were to transfer their home to the children and retain a legal life estate in the property, they would in essence have the right to live there the rest of their lives as well as rent the property, collect the rents and report the income on their individual income tax returns.
What is a Trust?
A legal devise satisfying the requirements of state law that places the legal control of property or funds with a Trustee. It also includes, but is not limited to, any legal instrument, devise, or arrangement that is similar to a trust, including transfers of property by a grantor to an individual or a legal entity with fiduciary obligations so that the property is held, managed or administered for the benefit of the grantor or others. Such arrangements include, but are not limited to, escrow accounts, pension funds, a similar devise as managed by an individual or entity with fiduciary obligations.
How to Create a Life Estate (Two Options)
- A Life Estate involving children or Family Members: This is a situation in which an individual, deeds their home to their children or a family member and within the deed reserves a legal life estate in the property transferred. If the property were owned by a married couple the deed would reflect the reservation of a joint and legal life estate in the property so transferred. The potential problem with this arrangement is that the children’s or family member’s names would now appear on the deed and they would have a vested remainder interest in that property as of the date of transfer. This results in a substantial loss of control for the individual who transferred the property as well as adverse gift tax and potential adverse income tax consequences in the future, as will be explored below.
- A Life Estate involving an Irrevocable Medicaid Trust: This is a situation where an individual deeds their home to an Irrevocable Medicaid Trust and in the deed reserves a legal life estate in the property. In the event the property is owned by a couple the deed would reflect the reservation of a joint and legal life estate in the property transferred. This transfer can be distinguished from the one mentioned above as here the children or family members are not involved in the transfer in anyway. This will result in the individual transferring the property to retain control over both the life interest and the remainder interest in the property. In addition, provided the trust is a grantor trust there will be no adverse gift or income tax consequences associated with this transfer, as will be explored in more detail below.
Planning Pointer: It is very important not to put the reservation of the life estate language in the trust itself as this could disqualify the trusts ability to protect the home from the costs of a nursing home.
What are the benefits associated with creating a life estate in which the remainder interest is transferred to the children or Family Members?
- Does giving my house to my kids while the parents retain a legal life estate in the home protect the entire home from nursing home costs?
Once this arrangement is established it will start the Medicaid five year look back period clock running but once that period has expired, the entire home and not just the remainder interest transferred to the children would be protected from the cost associated with long term care at least here in Massachusetts.
- Can a person have more than one life estate?
While you are permitted to have a life estate in numerous properties in general, the life estate in your primary residence is the only one that will be protected from the nursing home. The remainder portion of the vacation home or other property that you transfer to the kids would always be protected from the nursing home but the life estate portion you keep in these properties would be at risk for the nursing home. It is only the primary residence by virtue of it being your home that permits both the life estate interest and the remainder interest to be considered protected from the nursing home when you apply. Finally, this applies whether the life estate is created granting the remainder interest to the trust or to the kids.
- Does the five year waiting period for Medicaid eligibility apply to the creation of a life estate?
Yes, the remainder interest in the home transferred is not protected from the nursing until the expiration of five years from the date it was created. This rule applies whether the remainder interest was transferred to the kids or to an irrevocable trust.
- Is the life estate still protected from the nursing home even after the individual dies having spent time in the nursing home and having received Medicaid benefits?
It is important to check with the rules associated with your particular state as in some states such as New Hampshire, only the remainder interest would be protected from the cost associated with long term care following the completion of the look back period. The life estate portion of the property would remain at risk and subject to the estate recovery rules following the demise of the life tenant. However, in Massachusetts and any other state where the states ability to recover Medicaid benefits following the demise of the life tenant is limited to the probate assets of the estate then even the life estate would be protected from the nursing home following the demise of the life tenant. Probate assets are generally assets left in the decedents name as of the date of death. However, a life estate arrangement causes the asset to avoid probate and thus protect it form the states ability to recover against it following the demise of the life tenant.
- Does the life estate arrangement avoid the costs associated with the probate process upon the death of the life tenant?
By definition any asset in which an individual owns in their own name as of the date of their death would be included in the probate estate and subject to the costs associated with the probate process. However, as mentioned above, property owned in this life estate arrangement avoids being included in the probate estate even though it is includable in the individual’s gross estate for estate tax calculation purposes. Remember an individual can completely avoid estate taxes but still have probate costs if the trusts created are not funded during life. An individual can also completely avoid probate and still have an estate tax liability if the value of the estate exceeds the federal or state exemption amounts which are currently $5,340,000 federally, and $1,000,000 for Massachusetts. The goal is with planning to try and avoid both while at the same time protecting the assets from the costs of nursing home care.
- Will the beneficiaries of the life estate receive a full step up in basis for capital gains tax purposes upon the death of the life tenant and what are the tax benefits?
Although property subject to a life estate avoids probate and in many ways feels like it has been given away, it really has not been given away for estate tax purposes and will be includable in the individual’s gross estate following his demise under Internal Revenue Code Section 2036(a)(1) at the full fair market value on the date of the decedents death. This Internal Revenue Code Section indicates that the gross estate will include the value of all properties to the extent of which the decedent at any time made a transfer but retained possession or enjoyment of the property or the right to the income from the property. As shown in the definition above, a life tenant has effectively transferred the property and retained the right to enjoy it the rest of their lives thereby effectively causing the full value of the transferred property to be includable in their gross estate insuring the full step up in basis for capital gains tax purposes under IRC Section 1014. This basis step up means that the person who received the property as a result of another person’s death will get a cost basis in the property equal to the fair market value of the property as of the date of death of the person who died owning it. This can effectively eliminate capital gains tax on such property if it is sold shortly after the person receives it, as will be shown in the example below.
Planning Note/ Example: Let’s assume that mom and dad purchased their property 30 years ago and decided to establish a life estate by transferring the remainder interest to the children. Their cost basis in the property was $200,000 consisting of a $50,000.00 purchase price and they put $150,000.00 into the property in the form of capital improvements during their lives. As of the date of their death, that property was valued at $500,000.00. The children, assuming they do not live in the property, would now like to sell the property and are concerned about their income tax consequences associated with the sale.
Conclusion/tax benefits: Since the property is includable in the estate of the decedent because it was owned in a life estate, the children’s cost basis for income tax purposes will be stepped up or equal to the fair market value of the property as of the date of death i.e. $500,000.00. Therefore, when the property is sold for $500,000.00 with a basis equal to$500,000.00 there would be no resulting capital gains associated with that sale, thus enabling the children to keep the full $500,000.00 proceeds without paying any income tax.
- What are the tax implications if the property were instead just gifted outright to the children during the life of the parents?
Under this approach the parents would have in effect given their cost basis to the children along with the property. Therefore, if following the death of the parents the children would still like to sell the property, their basis would be the same basis as it was in the hands of the parents i.e. $200,000.00. If the property were ultimately sold for $500,000.00 minus a $200,000.00 cost basis in the hands of the children, the result would be a $300,000.00 gain. Assuming a 20% federal capital gains tax rate, 3.8% Obama care tax and 5% state tax rate the result would be an $86,400.00 income tax liability for the children. In this case, the use of a life estate would result in a savings of approximately $86,400.00.
- What are the income tax consequences of gifting a vacation home or a rental property outright to the kids?
The same carry over basis rules will apply resulting in the same adverse capital gains tax consequences as with the gift of the home as shown above. However, when gifting a rental property there is an additional adverse tax consequence and that is the depreciation recapture tax will also be there for the kids. This is a federal tax on the portion of the gain due to the depreciation of the property the decedent took as a deduction on his income tax return while it was rented. That portion of the gain will be taxed as ordinary income upon the sale of the property. In essence it is actually worse from a tax standpoint to give away a rental property during life for if the rental property is kept until death the full step up in basis also serves to eliminate the depreciation recapture as well for the beneficiaries. If the kids keep the property then they will have a full basis to depreciate during their lives if they choose to continue to rent the property, which will help to offset their income tax liability by enabling them to take a depreciation deduction against the rental income.
- What does the word life estate really give to the life tenant?
The retention of a legal life estate most importantly permits the parents or the individual owners of the life estate to continue to live there as long as they wish without fear of being thrown out by the children or the remaindermen. It also allows the life tenant to rent the property, be entitled to all of the rental income and expenses it generates. This rental income and expenses would simply be picked up on the life tenants’ individual income tax return. Finally, the life tenant can simply pay all their bills just like they used to prior to the establishment of the life estate.
- Once the property is in a life estate arrangement can the life tenant still get a reverse mortgage in the future?
Perhaps one important reason to use a life estate as a planning tool would be if you are concerned about running out of money and perhaps needing to tap the equity in your home through the use of a reverse mortgage to live on in the future. This reserved life estate would enable you to begin the Medicaid planning process and start the running of the five-year look back period currently, while at the same time reserving the opportunity to obtain a reverse mortgage sometime in the future without resetting the five year waiting period.
What are the pitfalls associated with creating a life estate in which the remainder interest is in the hands of the children or a family member?
- Does transferring the home or other real estate to the kids while retaining a life estate constitute a completed gift for gift tax purposes?
When an individual transfers their interest in property directly to the children or a family member and reserve a legal life estate they would have made a completed gift of the remainder interest to that person. In the event the value of the remainder interest exceeds the $14,000.00 present interest exclusion, a form 709 gift tax return should be filed. The $14,000 present interest exclusion is an amount that can be currently given away each year per person gift tax free and will not require the filing of a gift tax return. The value of the remainder interest is calculated using IRS table S in accordance with interest rates in effect on the date of transfer under IRC section 7520 which can be found at tigertables.com and once you determine the interest rate you go to table S to get the value of the remainder interest that correlates to the life tenants’ age.
For example: If the value of the property transferred was $400,000.00 and the individual was 66 years old and assume the applicable federal rate of interest on the date of creation of the life estate is 2.4% the Internal Revenue Code tables would tell us that the value of the remainder interest is 68.921% of the whole or $275,684 ($4000,000 x68.9217%). Therefore, the value of the gift made as of the date of transfer would be $275,684 and a gift tax return must be filed by April 15th of the year following the year in which the transfer occurred to report the resulting gift tax liability.
- Once the property has been transferred to the kids with this retained life estate does it expose the real estate to the children’s creditors?
Once the home is transferred to the children or a family member, the property becomes subject to their creditors and potential future divorces while the life tenant is still living. However, while the life tenant is alive, technically the creditors cannot move against the property, but certainly a lien may be placed upon the property and would remain there until the death of the life tenant at which point the collection process would begin. This arrangement can impact all the other siblings once a lien is on the property. Regardless of the timetable, there is no reason to be exposing your assets to your children’s creditors or future divorces while you are living.
2A. What access do creditors of the children have to property that is given outright to children instead of with a life estate attached?
Once the real estate is given away to the kids then their creditors will have full access to the property and this really puts the parents and the kids at risk. If the property is given equally to all the kids lets say 3 then you have just increased the creditor exposure by three times the normal amount. For example if any child got a divorce or had a financial difficulty that not only put the child at risk but if the parent is still living in the home then the parent now runs the risk of losing a place to live. There is very rarely a good reason to give away your home or other real estate to children while you as the parent are still alive as it not only results in creditor issues but also will have adverse income and gift tax issues associated with it.
- How much control do you give up once you transfer the home to your kids and retain a life estate?
Once the property has been placed in the hands of the children or a family member, one major loss of control is that the life tenant no longer retains the ability to change the beneficiary of the property.
For example: Let’s assume that mom transferred her home to her two sons, Bill and Tim, and reserved a legal life estate. Then over the years, mom needed additional care and Bill was always there to visit her, cook her meals, run errands for her, and help out in any other way that she needed so that she may continue to stay in the home as long as possible. Mom then decided that she would like to give her house to Bill in recognition of his care and attention over the years and seeks advise on how to accomplish this.
Conclusion : The problem with this arrangement is that mom can no longer change the beneficiary on the property without getting permission from Tim. In other words, if Tim does not wish to give up his half of the property then mom cannot accomplish her desire of giving the entire property to Bill. Therefore, this arrangement may result in a significant loss of control during the life of the life tenant.
- Can the life tenant sell the home after placing the remainder interest in the hands of the children and what are the income and gift tax ramifications?
The first major hurdle the life tenant faces prior to selling the property is getting the children’s permission. Assuming that the children or family member have agreed to sell the property, this arrangement would still result in adverse income tax consequences associated with the sale. If the property is sold, the gains (and proceeds) would be split between the life interest and the remainderman using the actuarial tables discussed above and the IRS Section 7520 rate that applies for the month in which the sale occurred. The basis would also be allocated at the time of sale using the 7520 rate. (See also Revenue ruling 71-122). The gain allocated to the life interest is eligible for the capital gains exclusion under Internal Revenue Code Section 121 provided the life tenant has owned and used the property as their primary residence for at least two of the last five years, but the gain allocated to the remainder interest holders is not eligible for this capital gains exclusion provided that the remaindermen have not used the property as his primary residence or that the remaindermen is not a grantor trust.
This capital gains exclusion applies to an individual who has owned and used his property as his primary residence for two of the last five years and entitles him to exclude $250,000.00 of capital gain attributable to the sale of his primary residence. This amount is increased to $500,000.00 for a married couple who has owned and used their property as their primary residence for two of the last five years. The ability to shelter this gain exists every two years. In this case, if the children have moved out of the home then the portion of the sale proceeds allocated to them as remaindermen would be subject to capital gains tax and not eligible for the exclusion under this rule. However, the life tenant would be able to apply this capital gain exclusion to his portion of the proceeds received from the sale thereby reducing and possibly eliminating any capital gain tax liability at least for the life tenant.
For Example: Let’s assume the life tenant decides to sell the home during their life for $600,00.00 with a cost basis of approximately $200,000.00. It is further assumed that the children agreed to sell the home. Assuming the life tenant is age 79 and the applicable federal interest rate found in the tiger tables mentioned above is 2.4% then based on the applicable table S life estate tables, the remainder interest is worth 81.741% of the property which translates into $490,446 ($600,000 x 81.741%). Upon completion of the sale the $490,446 of the proceeds would be allocated to the children as remaindermen and the balance of $109,554 of the proceeds would be allocated to the life tenants. This also assumes that 18.259% (100% – 81.741%) or $36,518 of the $200,000.00 cost basis would be allocated to the life tenant and 81.741% or $163,482 would be allocated to the children.
The result would be that $109,554 of the proceeds would be allocated to the life tenant minus a $36,518 of cost basis would result in a $73,036 capital gain. This gain would be reported on the life tenant’s, i.e. mom and dad, individual income tax return and since they have owned and used the property for two of the last five years as their primary residence, they would be able to avail themselves of the full $500,000.00 capital gain exclusion thereby eliminating any capital gains tax liability.
There would be a corresponding $490,446 allocation of proceeds to the children minus a $163,482 cost basis resulting in a $326,964 capital gain. However, since the children do not live in the property they would not be able to avail themselves to this capital gains exclusion and would have to pay federal and state income tax on the gain in the amount of approximately $94,166 (326,964 x 20% fed, 3.8% Obama care tax and 5% MA).
A final problem with this arrangement is that after the tax has been paid by the children as remaindermen, the portion remaining in the hands of the children or family member is an early inheritance. If the life tenant needs that money to live on or to purchase a new home, the life tenant would be forced to ask the children or family member to return it. In the event the children or family member decide to return it, they then would be subject to the gift tax rule in the event the amount given back to the life tenant exceeds the current $14,000 present gift exclusion. Either way the parent will have less money for themselves after the payment of the capital gains tax than would otherwise have been the case. A parent should not have to jump through so many hoops and encounter such adverse income tax consequences in order to protect their assets from the cost associated with long-term care. It is important to fully understand how a life estate operates and what your options are prior to gifting the remainder interest in your property to your children or a family member.
What is a Medicaid Income only Trust?
A Medicaid Irrevocable Income only Trust is a Grantor Trust that is designed to provide the donor or creator of the Trust with a significant degree of control over the asset inside the Trust, while at the same time insuring that the trust assets avoid the cost associated with the probate process and are protected from the cost associated with long term care after the expiration of a five year look back period from the date on which the assets were transferred to the Trust. This is a Trust where the donors or creators of the Trust say mom and dad should not serve as trustee of the trust. In the event a child or other family member were to serve as trustee the donor parent would retain the right to remove and replace the trustee thereby still retaining a large degree of control over the trust. We will also see as we move through this article that the parents as donors can change the beneficiaries of the trust thus effectively maintaining the ability to disinherit non-cooperative children just like they could prior to the establishment of the trust.
The donors or creators of the trust could place a home, vacation home, rental property or investments such as stocks, bonds, CDs and even bank accounts into the Trust. The parents would retain investment and managerial control over these assets in the trust by being granted limited trading authority over the assets even though not serving as trustee. Although, all of these types of assets may be placed in the Trust, our focus will be with on putting only real estate into the trust. Once the real estate is in the Trust the Donors or the parents would enjoy the ability to live there the rest of their lives, fix it up in any manner they desire, rent it and collect the rent, sell it and even use the proceeds from the sale to downsize and buy perhaps a smaller house as life events change. The parents can direct the trustee to accomplish these things because of the ability to remove the trustee any time they wish as well as disinherit the child if they become non cooperative. Finally, due to the grantor trust status of the trust all of these things can be accomplished without any of the adverse gift or income tax consequences encountered above, as will be explored in more detail below.
What are the benefits of creating a life estate in which the remainderman is an Irrevocable Income only Trust Instead of the Children or a Family Member?
In essence all of the same benefits exists here as existed when a life estate arrangement has been created in which the reamidnerman are the children or a family member as shown above. A review of the benefits are listed below.
- Protection from the nursing home: The assets in the irrevocable trust will be protected from the cost associated with long term care following the expiration of a five-year look back period.
- Avoid Probate: The assets inside the irrevocable trust will be outside the life tenant’s probate estate. By owning assets in the trust converts them to non-probate assets.
- Step up in basis: the assets in the irrevocable trustwill be includable in the decedents gross estate and receive the same step up in basis for capital gains tax purposes thereby reducing the capital gains tax consequences associated with a sale of the property following the life tenants demise as shown in the example above.
- Live there: The life tenant will be able to live in the property for as long they wish same as explained above.
- Rent it : The life tenant may choose to rent the property and the rent would simply be paid directly to the life tenant and would not be deposited or associated with the Trust in any manner. The life tenant would continue to report the rental income directly on their individual income tax return, form 1040 and provided there was no other income generating asset inside the Trust, the Trust would not be required to file an income tax return. However, even if the trust did need to file a tax return, form 1041, since the trust is a grantor trust it would not pay any tax and instead all of the trust income would simply flow through to the donor and be reported on their individual return and the tax calculated at their rates.
- Reverse Mortgage: As mentioned above, the life tenant would enjoy the same opportunities of reserving the right to obtain a reverse mortgage in the future in the event the life tenant needed additional money to live on and desired to tape the equity in the house to provide that additional capital.
- Do you loose the real estate tax abatements when you transfer property to an irrevocable Medicaid trust? If a person reserves a legal life estate in the property transferred to the trust then they will be able to retain any such real estate tax they were receiving prior to the transfer. This same rule applies to veterans benefits as well.
Why Creating a Life Estate in which the Remainder Interest is in an Irrevocable Medicaid Income Only Trust may be Superior to Putting the Remainder Interest in the Hands of the Children or a Family Member
- Does transferring a home or other real estate to an irrevocable income only trust have any gift tax ramifications?
If the donor or creator, meaning the parent, of the Trust has reserved a right in the Trust to designate the final beneficiary either during life or through a will after the execution of the irrevocable trust, this would cause any transfer of assets to the Trust to be an incomplete gift for gift tax purposes under Internal Revenue Code Section 2511 and Regulation 25.2511-2C. The effect of this reserved power by the donor, i.e. mom and dad, means that when the remainder interest in the home is transferred to the irrevocable trust in which the donor reserves a life estate, the transaction results in an incomplete gift for gift tax purposes thereby resulting in no gift tax consequences to the Donor or parents. This is a very different result from the one encountered when the property was given to the children with a retained life estate. However, a gift tax return is still required to be filed even though there would be no resulting gift tax liability (see example above for potential gift tax savings). It is this regulation that enables you to transfer such valuable real estate to the trust without paying any gift taxes.
- Once the home or other real estate is transferred to the irrevocable income only trust does it expose those assets to the children’s creditors?
The remainder interest in the property in this case is being transferred to the irrevocable income only trust and not to the children therefore there is no exposure of the asset in the trust to the children’s or other family member’s creditors during the life of the life tenant. This is particularly important if the child were to get a divorce after this trust is created. Under this arrangement the child could get a divorce and even be serving as trustee on the trust and the trust assets would not be subject to the divorce of the child.
- Do the parents lose all control over the home or other real estate once it is transferred to the irrevocable income only trust and can they still change the beneficiaries of the trust?
Since the remainder interest is once again being transferred to a Medicaid irrevocable income only trust in which the donors or creators of the trust i.e. mom and dad, have reserved the right to change the beneficiaries of the trust, generally limited to a class consisting of their children, grandchildren and charities, they will have retained a significant amount of control over the assets in the trust during their life. This class of beneficiaries is generally determined at the time the trust is created. This power to change the beneficiaries is called a limited power of appointment and provides a great deal of flexibility and control for the parents. This level of flexibility is important as life events occur over time that may impact the way a parent may want to leave asset to their family members and this limited power of appointment provides all the flexibility needed.
For example: Let’s assume that the same fact as shown above except this time mom transferred the property to this irrevocable trust rather to her sons Bill and Tim and reserved a legal life estate. Now, after many years of care and attention provided by Bill mom desires to give the entire property to Bill instead of equally to Bill and Tim as originally provided in her Trust. Since mom has retained the power to change the designated beneficiaries of the Trust, she may accomplish her objective of leaving the house directly to Bill and cutting out Tim without the need to get Tim’s permission or notify Tim in any manner. This retained power also allows the donor, i.e. mom, to freely revisit the disposition of her assets as life events unfold, which she was clearly unable to do when the property was gifted to the children with a reserved life estate. This power allows her to pick and choose which assets go where and to whom. The donor might still want Tim to get some monetary assets and this power allows her to do that.
- Can the property be easily sold after it is transferred to the irrevocable income only trust and what are the income tax ramifications?
In this case the life tenant, mom and dad or any individual would be able to freely sell the property without the need to obtain the remaindermen’s permission. This arrangement allows mom and dad to control the life interest as well as the remainder interest since the remainder interest has been transferred to the irrevocable trust in which mom and dad control the trustee by retaining the ability to remove the trustee at any time or remove the trustee child as a beneficiary if he or she does not cooperate, as mentioned above.
With regard to the income tax consequences associated with the sale, the sale proceeds will still need to be split between the life tenant and the remaindermen in the same manner as described above. However, since the donor of the trust, i.e. mom and dad, reserve that right to designate the income and principal of the trust to the final beneficiaries during their life, this makes the trust a grantor trust, under Internal Revenue Code Section 674(a) thus eliminating the adverse income tax consequences experienced when the remaindermen are the children.
In other words, the term grantor trust means that all of the income from the trust will be deemed to be the donors for income tax purposes, thereby allowing the portion of the sale proceeds allocable to the irrevocable trust to be eligible for the capital gains tax exclusion associated with the sale of their primary residence, thereby eliminating any adverse income tax consequences associated with the sale. In addition, since the portion of the proceeds equal to the remainder interest is being deposited into the trust and not into the hands of the children, as happens when the children are the remaindermen, there is no early inheritance passing to the children. Furthermore, the life tenant by directing the trustee as mentioned above, would continue to be able to use the proceeds in the irrevocable trust to purchase another home or a downsize condo, or simply invest the money and live off the income. Finally, this sale and repurchase transaction will not restart the five year waiting period for Medicaid eligibility purposes.
For example: Let’s assume the same example as mentioned above, in which the life tenant decides to sell the home during their her life for $600,00.00 with a cost basis of approximately $200,000.00. First, since the children are not involved in the transaction the life tenant does not require their permission to complete the sale. Second, assuming the life tenant is age 79 and based on the applicable life estate tables used in the above example, this means that 81.741% or $490,446 (600,000 x 81.741%) of the proceeds would be allocated to the trust as the remainder beneficiary and 18.259% or $109,554 (600,000 x 18.259%) of the proceeds would be allocated to the life tenant or mom and dad in this case. This also assumes that 18.259% or $36,518(200,000 x 18.259%) of the $200,000.00 cost basis would be allocated to the life tenant and 81.741% or $163,482 (200,000 x 81.741%) to the irrevocable trust.
The result would be that $109,554 of the proceeds would be allocated to the life tenant minus a $36,518 cost basis would result in a $73,036 capital gain. There would also be a corresponding $490,446 allocation of proceeds to the irrevocable trust minus a $163,482 cost basis resulting in a $326,964 gain seemingly at the trust level. However, since the Trust is a grantor trust, as mentioned above, this would cause the $326,964 capital gain at the trust level to be allocated to the life tenant’s tax return where it will be added to their own $73,036 gain. Therefore, the full $400,000.00 gain would be reported on the Life tenant’s, i.e. mom and dad, individual income tax return and since they have owned and used the property for two of the last five years as their primary residence, they would be able to avail themselves of the full $500,000.00 capital gain exclusion thereby resulting in no tax liability. This is in stark contrast to the result when the property is transferred to the children with the retained life estate, which resulted in a tax liability of approximately $84,600.
One Common Benefit and Negative Associated with Retaining a Life Estate as a Planning Tool Under Either Circumstance
There are really two common benefits associated with creating a life estate either in connection with a trust or giving the remainder interest to the kids. First, it allows the life tenant an opportunity to obtain a reverse mortgage in the future in the event they were to run out of money to live on. A reverse mortgage enables a life tenant to tap the equity in the house to live on without the need or worry of paying it back during their life. However, this loan would be required to be paid back following the life tenant’s demise. Second, the reservation of a life estate is going to ensure that the life tenant is able to maintain any real estate tax abatement they may have been receiving prior to the establishment of the life estate.
The real problem with reserving a life estate whether the remainder interest is in the hands of the children or in the irrevocable trust is that when the property is sold a portion of the proceeds must be allocated to the life tenant. Although it is true that the life tenant may need these proceeds to live on they are also re-exposed to the cost associated with long-term care.
For example: If a husband and wife created a life estate arrangement at the age of 65 and one spouse died at age 75 and the surviving spouse at age 79 decides it’s time to sell the property and downsize to a smaller condo or perhaps rent if they choose. Based on the life estate tables, a 79-year-old life tenant would be entitled to 18.259% of the sales proceeds. If the property being sold is worth $600,000.00, then $109,554.00 would be allocated to the life tenant and once again re-exposed to the cost associated with long-term care. Even if the life tenant desired to place those proceeds into the irrevocable trust, mentioned above, that would generate a new five year wait before those assets would be protected from the cost of long term care for a person who is already age 79. Whereas, if the entire property were placed into the irrevocable trust, mentioned above, without the reservation of a legal life estate, and the property were to be sold, all of the proceeds would be deposited into the irrevocable trust. There would be no adverse income tax consequences due to the grantor trust rules mentioned above, and the proceeds would be available to be used to purchase the downsized condo if desired. In the event that a new condo is purchased by the trustee of the trust, that transaction would not result in a new five year wait period. In other words, if the property that was sold from the trust was in the trust for five years prior to the sale, then the new property and any excess proceeds remaining in the trust would be fully protected from the cost associated with long term care without the need to wait another five years.
Conclusion: There is a significant loss of control along with potential adverse gift and income tax consequences associated with the transfer of your home or any real estate to your children while retaining a legal life estate. Whereas, there is much more control retained and no adverse gift or income tax consequences associated with transferring the house or any real estate to a Medicaid irrevocable income only trust while retaining a life estate or not. The life estate allows the individual to obtain a reverse mortgage in the future in order to maintain their life style or continue to live in the house. In addition, the retention of a life estate will allow the life tenant to continue to retain any residential real estate tax abatements they may have been receiving.
Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors. Armstrong Advisory Group, Cushing & Dolan and Securities America Inc. 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. 09/2014 AT #1003113.1