Legally Speaking: Is a life estate the way to go?

Legally Speaking: Is a life estate the way to go?

By Linda M. Toga, Esq.

Linda Toga Esq.

THE FACTS: Many of my friends have told me that I should transfer my house to my son and retain a life estate.  

THE QUESTIONS: What are the pros and cons of doing that?

THE ANSWER: People often transfer their property to their children and create life estates because they believe it is the best way to increase their chances of being Medicaid eligible or to avoid probate. In most cases, there are better ways to achieve those goals. 

Before the Medicaid look-back period was changed to five years for all nonexempt transfers, life estates were a very popular part of Medicaid planning. However, since the look-back period is now the same whether you transfer a residence and retain a life estate or put the residence in an irrevocable trust, there is no advantage to creating a life estate when it comes to the look-back period. 

The downside of a life estate from a Medicaid planning perspective is the fact that, if the house is sold during your life time, you are entitled to a portion of the proceeds from the sale. The percentage of the proceeds allocated to you would be governed by life expectancy tables and is surprisingly large. 

For example, if you, as the life tenant, are 80 years old when your $300,000 house is sold, you will be entitled to approximately $130,000 of the proceeds. In the context of a Medicaid application, that $130,000 will be deemed an available resource and may result in a denial of benefits. This is true even if you created the life estate more than five years before you apply for Medicaid. 

If, on the other hand, you transferred the house into an irrevocable trust, even if the house was sold, the proceeds would be fully protected in the trust after the five year look-back period. 

With respect to avoiding probate, if you transfer your house to your son during your lifetime and create a life estate, the house will not be subject to probate when you die, the value of the house will not be included in your gross taxable estate (although the value of the transferred share may be subject to federal gift tax) and you will continue to enjoy any real estate tax exemptions that were applicable to the property before you deeded the house to your son. 

However, if the house is in your son’s name, his creditors can attach liens or judgments to the property. If you create a life estate, you will be required to file a gift tax return reporting the gift of the property to the IRS. 

Finally, by creating a life estate you may be subjecting your son to a capital gains tax liability. That is because your son will not get the step up in basis when you gift him the house that he would get if he inherited your house after your death. 

For example, if you paid $150,000 for the house 20 years ago, your son’s basis in the house if you gifted it to him would be $150,000. If he sells the house after you die, he will have to pay capital gains tax on the increased value of the house. 

If, on the other hand, he inherits the house after your death, he will get a step up and his basis in the house will be the date of death value. Unless he holds on to the house for an extended period of time, it is unlikely that your son will have any capital gains tax liability. 

If your goal in creating a life estate is to avoid probate, a better alternative to a life estate is a revocable trust. Although transferring your house into a revocable trust does not provide protection from estate taxes, it does avoid the need for filing a gift tax return, it protects the house from your son’s creditors and it will allow your son to get a step up in basis when he inherits the house after your death. 

There are clearly many issues to consider when deciding whether a life estate, revocable trust or irrevocable trust offers the best solution for you. The cost of each option is also a consideration. Since creating a life estate can have far-reaching consequences, it is important to discuss your goals and your options with an experienced attorney before taking action. 

Linda M. Toga, Esq. provides personalized service and peace of mind to her clients in the areas of estate planning, real estate, marital agreements and litigation. Visit her website at www.lmtogalaw.com or call 631-444-5605 to schedule a free consultation.

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