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 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.
