Part One of a Three Part Series
Editor’s Note; This is the first
installment and an exclusive three-part series of articles in REBA News
directed to transactional and general practice attorneys, exploring the use of
life estates and irrevocable trusts in estate planning and Medicaid
planning. The first installment will
focus on the SJC’s landmark Daley case and discuss what is a life estate vs. a
trust, along with related tax implications of carryover basis vs. step-up in
basis.
The second installment, which will be published in the March/April
issue, will explain some of the gift and income tax pitfalls associated with
life estates and remainder interests, with some detailed examples.
The concluding installment, to be published in the May June issue, will
explore creating a life estate and transferring the remainder interest to a
Medicaid irrevocable trust along with the related gift, estate, and income tax
implications.
Congratulations to REBA on submitting an amicus brief in
support of the applicant in the Daley case,
arguing that a life estate interest is a property interest and not an interest
in trust. In a recent Massachusetts Supreme Judicial Court
decision, Mary E. Daley, Personal
Representative v. Secretary of the Executive Office of Health and Human
Services (the Daley case), the Court
reversed the Superior Court’s decision and provided clarity in determining that
a life estate reserved in a deed is in fact a property interest and not an
interest in trust. While this may seem
like the common sense result, a little history of the case and circumstances surrounding
it is in order to fully appreciate the gravity of the decision. The article will also explore the pros and
cons of creating a life estate with the remainder interest in the hands of
children versus the remainder interest into a Medicaid irrevocable grantor
trust along with the income, gift, and estate tax implications.
First, let’s look at the history of the Daley case.
In the Superior Court of Daley
v. Sudders, Worcester Superior Court
Civil Action Number 15 CV 0188D (“Daley”),
the Court determined that a life estate was essentially an interest in a trust
and, as a result, trust assets were considered available for purposes of
MassHealth eligibility. The facts of the
case are quite simple and common but the result was troubling.
In Daley, an
individual who owned a condominium transferred her interest in the condominium
to an irrevocable trust and retained a life estate in the property in a
quitclaim deed and continued to live there for approximately six years until,
for health reasons, the life tenant was admitted to a nursing home. The individual applied for long term care and
the application was denied. The Superior
Court upheld the denial for two reasons.
First, the Court found that the assets of the trust (i.e., the condominium) were countable
because the applicant had retained a life estate in the property.
Specifically, the Court stated:
“Property held in an irrevocable trust
is a countable asset where it is ‘available according to the terms of the trust[.]’ 130 Code of Massachusetts Regulations Section
520.023(C)(1)(d). If a Medicaid
applicant can use and occupy her home as a life tenant, then her home is ‘available,’ See
Doherty v. Dir. of the Office of Medicaid, 74 Mass. App. Ct. 439, 441 (2009)
(home was available because applicant retained the right to reside there during
her lifetime.)[[1]]
“This Court concludes that Mr. and Mrs.
Daley’s condominium was available to them because they retained life estates
under the deed, and continued to use and live in it after establishing the
Trust. It is undisputed that they lived
together at the condominium for about six years after they established the
Trust until Mr. Daley was required to be admitted into the nursing
facility. It is also undisputed that
Mrs. Daley continues to live in the property.”
The Court also found that as a result of certain other
provisions contained in the trust, the trust assets also nevertheless would be
considered countable. This article
focuses only on the Court’s reasoning regarding retention of the life estate
and makes no conclusion about the correctness of the other provisions of the
trust that caused the assets to be countable.
The Massachusetts Supreme Judicial Court in the Daley case stated that since the Daley’s retained a life estate in the deed and transferred the remainder interest in their home to the trust, that the trust has no property interest in the home during the Daley’s lifetime. Furthermore, their continued right to live in the home or collect income from the home cannot be deemed income received from the trust since the trust has no property interest during the Daley’s lifetime. Instead, the Court acknowledged that the life estate is an asset of the Daley’s that could be sold, mortgaged, or leased. The Court further acknowledged that if the property were sold, the life tenant is entitled to a portion of the proceeds calculated in accordance with an actuarial evaluation of the life estate. Finally, the Court concludes that “where the irrevocable trust does not own the life estate in the applicant’s primary residence, the continued use of the home by the applicant pursuant to his or her life estate interest does not make the remainder interest in the property owned by the trust available to the applicant.” This ruling reversing the Superior Court provides clarity that a life estate is in fact a property interest and not an interest in trust.
Since life estates are so commonly used, but perhaps
mistakenly understood, the balance of the article will explore the pros and
cons of creating a life estate with the remainderman the children versus the
remainderman being an irrevocable Medicaid grantor trust and the related
income, gift, and estate tax implications.
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.
130 Code of Massachusetts Regulations 15.001. 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 and expenses 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 Donor to an individual or a legal entity with
fiduciary obligations so that the property is held, managed or administered for
the benefit of the Donor or others. Such
arrangements include, but are not limited to, escrow accounts, pension funds, a
similar device as managed by an individual or entity with fiduciary
obligations.
1.
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 the life tenant’s demise
under Internal Revenue Code Section 2036(a)(1) at the full fair market value on
the date of the decedent’s 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 for the rest of their lives thereby
effectively causing the full value of the transferred property to be includable
in their gross estate ensuring the full step-up in basis for capital gains tax
purposes under IRC Section 1014(a). However,
in the event husband and wife had a life interest in the property, there would
only be one-half included in the estate of the first spouse to die. This would result in only a one-half step-up
in basis. Upon the death of the
surviving spouse, again only a one-half interest would be included in his/her
estate which would result in only a one-half step-up in basis. Basis by definition is essentially what you
have paid for the property or what you are deemed to have paid for the
property. 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. In other words, it is as if the person who inherited the
property paid fair market value for it even though they did not. 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
purchase price and they put $150,000 into the property in the form of capital
improvements during their lives. As of
the date of their death, that property was valued at $600,000. 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.
$600,000. Therefore, when the property
is sold for $600,000.00 with a basis equal to $600,000 there would be no
resulting capital gains associated with that sale, thus enabling the children
to keep the full $600,000 proceeds without paying any income tax.
2.
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. See IRC Section 1015 (for carryover basis
rules.) If the property was ultimately
sold for $600,000 minus a $200,000 cost basis in the hands of the children, the
result would be a $400,000 gain.
Assuming a 20% federal capital gains tax rate, 3.8% Obama care tax, and
5% state tax rate, the result would be an $115,200 income tax liability for the
children. In this case, the use of a
life estate would result in a savings of approximately $115,200. Please think
twice before you ever gift your house to your children while you are living, as
nothing good can come from it.
Editor’s Note: This is the first installment of a three-part
REBA News series. The second installment will be published in the
January/February issue. It will discuss
the tax pitfalls of life estates with the remainder interest in the children
and some preferred alternative options.
Todd Lutsky, of Cushing and Dolan, P.C. Concentrates in the preparation
of estate plans, including the use of revocable trusts, joint trusts,
irrevocable life insurance trusts, qualified personal residence trusts and
family limited partnerships. He has a specific interest in Medicaid and asset
protection planning for the elderly, assisting clients with the Medicaid
application, preparation and eligibility process of obtaining MassHealth
benefits, fair hearings, and advanced Medicaid planning and the preservation of
assets through the use grantor irrevocable income only trusts. He hosts his own radio show called, “The Legal
Exchange with Todd Lutsky,” and it can be heard every Saturday at 5:00PM on
WRKO 680AM and on four other local stations. Todd can be contacted at tlutsky@cushingdolan.com.
Co-chair of REBA’s estate
planning, trusts and estate administration section, Leo Cushing is the founding
Partner of Cushing & Dolan, P.C., specializing in closely held businesses,
taxation, sophisticated estate planning, elder law and real estate. Leo's
practice includes all aspects of sophisticated estate planning techniques,
asset protection, trust planning, charitable giving and resolution of tax
controversies. Leo has written and
lectured extensively on all aspects of taxation and estate planning. Leo is a
much sought after speaker as he is able to articulate complex issues in a way
that is clear, concise and easy to understand.
Leo’s email address is lcushing@cushingdolan.com.
[1] Doherty did
not involve a retained life estate; rather, in Doherty the applicant deeded the entire fee into trust, which contained
a provision that allowed the applicant to reside in the home. Doherty,
74 Mass. App. Ct. at 441.
