OPERATIONAL GUIDE TO LIFE ESTATES VS. IRREVOCABLE TRUSTS PART TWO

Leo J. Cushing and Todd E. Lutsky

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 15^th 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.

Editor’s Note:  This is the second installment of a three-part REBA News series.

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.

OPERATIONAL GUIDE TO LIFE ESTATES VS. IRREVOCABLE TRUSTS PART ONE

Leo J. Cushing and Todd E. Lutsky

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.

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[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.