What is a Life Estate and Why Should we Avoid Them?

I hope it is a given, that we should not own real estate in our individual names. Some thoughtful legal planning will enable our beneficiaries to avoid probate and protect the value of the home from Taxes, Long Term Care and other liabilities.

  1. The most commonly used planning for the home is the WORST. This is an outright transfer of title to children or other beneficiaries. Even IF my children are nice people and don’t kick me to the curb, there will be negative tax consequences: We will lose our STAR and other property tax exemptions AND the children will ultimately be taxed on the difference between my original purchase price and the eventual sale price.
  2. Cognizant of the drawbacks of outright transfers, some practitioners create “Life Estate” deeds. There is logical appeal to this. My children are named as the “Remaindermen” (think beneficiary) on the deed, but my name remains “as to” lifetime ownership rights. This will avoid probate and capital gains consequences for a sale after the parent’s death. It will also start the running of the so-called 5 year lookback period for nursing home Medicaid eligibility. Sounds great- and it is, UNLESS there is a problem-and there is almost ALWAYS a problem! If, for example, I want to sell the home during my life, I will need my children’s written consent and there will be capital gains consequences. This is because I no longer own 100% of the home. Therefore, I cannot utilize my entire $250,000 capital gains tax exclusion provided for in the Internal Revenue Code (Section 121). Moreover, if the home is sold once I am in a nursing home- even after 5 years have passed, the Medicaid program will be entitled to that portion of the sale proceeds attributable to the retained life interest. This is measured by reference to acturarial tables. For example, if I am 80 years old, I am deemed to own 44 % of the home. On a sale of $500,000, the nursing home will get $220,000! What if the family opts not to sell the home, and instead rents it out to generate cash to pay carrying expenses? This won’t work, because the nursing home is entitled to all of my income- including rental income on life estate property.

    Even if I never enter a nursing home and do not sell the home during life, the life estate will subject my home to my children’s future possible liabilities. This is because the “Remainder Interests” are “Vested”, and therefore reachable by creditors.

  3. If an outright transfer and life estate are both problematic, what should we do with real estate to guard against liabilities, probate and capital gains taxes? The answer is easy- a TRUST! Should the Trust be Revocable or Irrevocable? This answer isalso easy-somewhere in the middle. Contrary to popular belief, there are dozens of different trust structures. The selection and creation of the optimal trust to protect real estate and other assets is not easy. It depends upon many factors specific to one’s circumstances. Sadly, the one-size-fits all trust forms for sale online, usually fit no one. With some accurate information, and nuanced planning, we can create a trust to give our loved ones a tax and time efficient transfer while retaining control during our lives.