Concluding a Three-Part Series for REBA News Readers
Editor’s Note; This is the third and final 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 focused 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 explained some of the gift and income tax pitfalls associated with life estates and remainder interests, with some detailed examples.
This 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 Some of 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?
1. Step-up in basis: The assets in the irrevocable trust will be includable in the decedents’ gross estate and receive a step-up in basis for capital gains tax purposes. Since the Donor will have transferred the property to the trust and retained a life estate in the deed that would cause IRC Section 2036 to apply and cause the inclusion of the home into the Donor’s estate. This inclusion would cause IRC Section 1014(a) to apply resulting in the basis of the property to be stepped-up in the hands of the beneficiary. This will reduce the capital gains tax consequences associated with a sale of the property following the life tenants’ demise, if sold by the beneficiary shortly after their demise.
2. 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. (See Daley decision above.) 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, just like it was done before they created the Trust.
3. Sell the home: The Donors can sell the home any time they wish and do not need the permission of the trustee. In addition, there will be no adverse income tax consequences associated with the sale as was the case when the house was transferred to the children, as shown above. An example of such a sale will be explored below.
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, or reducing your gift or estate tax exemptions or reducing your Massachusetts exemption amount.
- 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 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. This is accomplished by giving the Donor the right to remove and replace the trustee provided however that the replacement trustee cannot be the Donor or Donor’s spouse.
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, generally limited to charities but excluding nursing homes that maybe a charity or a nonprofit and governmental entities, 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, as shown above.
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, via IRS Section 121, 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 and the proceeds of the new home in the trust would remain protected from the nursing home. Remember this transaction does not result in any new asset going into the trust but instead it is simply a reinvestment of assets that were already in there.
For Example: Let’s assume the same example as mentioned above, in which the life tenant decides to sell the home during their life for $600,000 with a cost basis of approximately $200,000. 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 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 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 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 $96,166. Not to mention the fact that the children did not receive any of the proceeds, which allow mom and dad the ability to use the income from the proceeds to live on for the rest of their lives. Finally, this arrangement does not expose the proceeds to the kids’ creditors.
The Daley case made it clear that a life estate is a property interest and not an interest in trust. However, as you can see from this article, there are implications and considerations to think about when using a life estate arrangement. Although life estates are commonly used, they may not always be fully understood.
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 firstname.lastname@example.org.
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 email@example.com.