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.
Conclusion:
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 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.
