Using a life estate deed as a way to protect real estate from long-term care costs has been a common planning technique for decades. A life estate deed typically works like this: parents sign a deed transferring their home to their children for nominal consideration (i.e. $1.00). The deed includes a provision stating that the parents “retain the right to use and occupy the property during their lifetimes,” a so-called “life estate” in the property. Upon the death of the parents, the life estate ceases to exist and the children own the property free and clear of any lien for long-term care costs.
There are some downsides to using a life estate deed which can be eliminated if the parent conveys the property to an irrevocable trust. This has made irrevocable trust planning very popular in the last several years. However, the recent attacks on the use of irrevocable trusts by MassHealth, the agency that administers the Medicaid program in Massachusetts, have caused elder law attorneys to revisit the use of the simple life estate deed.
Here are five consequences to be aware of when considering the transfer of your real estate with a retained life estate.
- Five-year ineligibility period: The transfer is a gift under the Medicaid (MassHealth) rules and the parents will be ineligible for Medicaid benefits to pay for their long-term nursing home care costs for five years following the transfer. Under the current Medicaid rules, once the five-year ineligibility period has passed, the parents would be eligible for Medicaid benefits to pay for the cost of their care, assuming they otherwise meet the eligibility criteria.
- The property will be subject to a lien for the life estate Medicaid benefits. It is important to understand that if the parent receives Medicaid benefits, whether in a nursing home or in the community, the Commonwealth will place a lien against the parent’s property. However, if the parent owns a life estate in the property, the Medicaid rules prevent the state from forcing the parent/life estate holder to sell the property during the parent’s lifetime. Upon the death of a Medicaid beneficiary, the state can collect the amount it paid out on behalf of the person from his probate estate. A person’s probate estate consists of assets in his individual name. Because the retained life estate disappears upon the death of the parent, it is not a probate asset and therefore the state cannot enforce its lien against the property under current law. It is important to understand that if the property is sold during the parent’s lifetime, the lien will have to be satisfied from the parent’s share of the sale proceeds.
- Children’s creditors. If you transfer your home to your children, they will be the owners of the property even if you retain a life estate. That means your children’s creditors may be able to place a lien against your home for your children’s debts. However, when the parents have retained a life estate, the creditors of a child cannot force the sale of the property to satisfy a child’s debt. That is because a child’s creditors are not in any better position than the child. Since the child could not sell the property and force the parents out of the property, neither could a child’s creditor. The creditor will have to wait to enforce its claim until after the parents die. Having said that, parents need to know that a recent bankruptcy case resulted in the court ordering the sale of property owned by the debtor child, in which the still-living parent had a life estate. When the house was sold, the father received his share of the proceeds. However, since the value of a life estate is calculated based on the life expectancy of the life estate holder at the time of the sale, the value of the parent’s life estate decreases with every birthday. The end result of this case was that dad received a little bit of money when the house was sold, but had no place to live.
- Stepped up basis/estate tax inclusion. A big advantage of retaining a life estate in property that is transferred: The full value of the property is taxable in the estate of the life estate holder at death for estate tax purposes. While it may seem counterintuitive to want assets to be included in the taxable estate, for Massachusetts estates valued at $1 million or less, this is actually a benefit. Under current law, assets that are included in a taxable estate receive a “stepped-up” basis at the owner’s death equal to the fair market value of the asset. For example, if I bought my house for $50,000 many years ago and it is now worth $300,000, upon the sale of the house during my lifetime there would be capital gain of $250,000 ($300,000 – $50,000). I would not have to pay any capital gain tax because there is a rule in the tax law that allows a person who has owned and occupied a home for two out of the five years preceding the sale to exclude $250,000 of capital gain on the sale. If I gave my house to my children outright, without retaining a life estate, when my children sell the property they will be have to pay capital gain tax on $250,000 because the home is not their primary residence. But, if I retain a life estate in my home when I transfer it to my children, my house will be included in my taxable estate at my death and my children’s tax basis in the property will be the then current fair market value of the property. So if the property is worth $300,000 at my death, and my children sell it for $300,000, there will not be any gain, so no tax will be due. In this example, that means about $50,000 of tax savings.
- Capital gain exclusion on sale of primary residence. As a general rule, you should not transfer your home to your children if you are planning on selling the property. However, times change and sometimes property that was transferred to children needs to be sold during the parents’ lifetimes. It is important to understand that if this happens, there may be capital gain tax on the sale that would have been avoided if no transfer of the property to the children had been made. That is because the tax laws permit an individual to exclude up to $250,000 of capital gain on the sale of her primary residence, provided she has owned and occupied the property for two out of the five years preceding the sale. For a married couple, the exclusion is $500,000. However, if your children own an interest in your home and if they do not occupy the home as their principal residence, they will not be able to exclude the gain on their portion of the sale.
Another consequence to be aware of is that if the property is sold during the parent’s lifetime, the parent will be entitled to some (not all) of the proceeds. This is not necessarily a bad result, but if the parent is in a nursing home or about to go into a nursing home when the property is sold, a portion of the sale proceeds will be countable assets of the parent. The value of the parent’s life estate interest is calculated based on the age of the life estate holder and an interest rate mandated by the IRS. For example, in March 2017 the current value of a life estate held by a parent who is 80 years old is about 17.4% of the value of the property. If the property is sold for $400,000, the parent will receive 17.4% of the proceeds, or $69,600. If the parent is residing in a nursing home with Medicaid paying for the cost of care, then the receipt of $69,600 from the sale of his former home will cause him to become ineligible for Medicaid until those proceeds are spent down.
While transferring property with a retained life estate can be an excellent long-term care planning tool, there are significant consequences that property owners should understand before undertaking this planning. If you are wondering whether this type of planning would be good for your family, consult with an experienced elder law attorney to make sure you do not end up facing one or more unexpected outcomes.
Attorney Suzanne R. Sayward is certified as an Elder Law Attorney by the National Elder Law Foundation. She is a partner with the Dedham firm of Samuel, Sayward & Baler LLC. This article is not intended to provide legal advice or create or imply an attorney-client relationship. No information contained herein is a substitute for a personal consultation with an attorney. For more information visit www.ssbllc.com or call 781/461-1020.