Part Two of a Three Part Series
Editor’s Note; This is the second 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 concluding installment 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.
What are the Tax Pitfalls Associated with Creating a Life Estate in which the Remainder Interest is in the Hands of the Children or a Family Member?
1. 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 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 for that interest rate to get the value of the remainder interest that correlates to the life tenant’s age. Then you multiply the value of the property by that remainder percentage to get the value of the gift.
For Example: If the value of the property transferred was $600,000 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 corresponding Internal Revenue Code Table S for that interest rate would tell us that the value of the remainder interest is 68.921% of the whole or $413,530 ($600,000 x 68.9217%). Therefore, the value of the gift made as of the date of transfer would be $413,530 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. While no actual tax may be due because the giver would likely just reduce federal their gift tax exemption of currently $5,490,000 by the gift tax liability. While there is no Massachusetts gift tax, the value of the gift would reduce the current Massachusetts $1,000,000 estate tax exemption or filing threshold.
2. 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 tenant 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 rulings 71-122, 66-159 and 85-45). The gain allocated to the life tenant 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. However, the gain allocated to the remainder interest holders is not eligible for this capital gains exclusion provided that the children have not used the property as their primary residence.
This capital gains exclusion applies to an individual who has owned and used his property as his/her primary residence for two of the last five years and entitles him/her to exclude $250,000 of capital gain attributable to the sale of his primary residence. This amount is increased to $500,000 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 $600,000 with a cost basis of approximately $200,000. 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 on the month of sale found in the tiger tables mentioned above is 2.4% then based on the applicable corresponding 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 tenant. This also assumes that 18.259% (100% - 81.741%) or $36,518 ($200,000 x 18.259%) of the $200,000 cost basis would be allocated to the life tenant and 81.741% or $163,482 ($200,000 x 81.741%) 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. However, 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 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 by the children 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 and instead compare the benefits of transferring the remainder interest to an irrevocable Medicaid income only trust.
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 email@example.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 firstname.lastname@example.org.