By Erin Duques
For many of us, our home is our most valued possession. It’s usually one of the assets each of us is most interested in protecting, with the ultimate goal of being able to leave something to children or other family members after we’re gone.
With the goal of asset protection in mind, why wait until after death? Why not simply gift the property to those beneficiaries during your lifetime? One approach is to make a lifetime transfer while reserving a life estate. There are pros and cons to this approach.
What is a Life Estate?
A life estate is a type of joint ownership of real property (homes, land, anything immovable), whereby an individual has exclusive use and possession of his or her home until death, at which time ownership passes to the other owner.
In these kinds of arrangements, the original owner of the property is called the “life tenant,” and the person who ultimately obtains ownership is called the “remainderman” (or “remaindermen” if there are multiple individuals).
The life tenant is able to maintain control of the property, and is also responsible for paying the carrying costs (taxes, insurance, etc.). The life tenant cannot sell or mortgage the property without the permission of the remainderman, and the remainderman cannot take possession of the property until the life estate is extinguished upon the death of the life tenant.
Why retain a Life Estate?
There are various reasons an owner might want to transfer property, but if he or she wants to continue living in or collecting income from a property, it is risky to rely on a mere promise from the transferee. While the transferee might initially be willing to cooperate completely with the owner’s wishes, situations change.
Transferring property while keeping a life interest ensures that the life tenant has legal access to and use of the property during the life tenant’s lifetime.
2. Probate Avoidance
Property owned by a life tenant and a remainderman is excluded from the probate estate of the life tenant upon his or her death, meaning it will pass automatically to the remainderman without the need for probate court involvement.
While the ability to avoid probate makes the process of transferring property ownership much simpler and faster, it’s important to remember that the property will still be part of the life tenant’s taxable estate. In Connecticut, this means that the property must be reported on the estate tax form (706 or 706NT). Probate fees, owed by the estate, are based upon the value of the gross taxable estate, including property in a life estate.
If property is transferred from parent to child during the parent’s lifetime, the child recipient takes the property with the owner’s cost basis. This is important because the cost basis is used to calculate the capital gains tax owned when the property is sold.
Say, for example, that John gifts his children a home he purchased 40 years ago for $50,000. When John dies and the children sell the house for $375,000, they will have to pay capital gains tax on the $325,000 gain. However, if John retains a life estate, then the cost basis will be “stepped up” to the fair market value of the property on the date of John’s death, significantly reducing the kids’ tax exposure.
What are the risks?
1. Loss of Control
Even with a life estate, the life tenant still relinquishes some control of the property. As mentioned above, the life tenant cannot sell or mortgage the property without the remainderman’s consent. While this may seem like a small matter (parents often assume their children will comply with their wishes), unexpected changes in life circumstances and relationships may cause disagreements. You just never know what might happen.
With a life estate, the property is exposed to the creditors of both the life tenant and the remainderman. In other words, your kids’ financial problems become your financial problems. This can put the property at risk if, for example, one of the children to whom the parent has transferred the property has issues with creditors or is sued. Such a situation could result in a creditor placing a lien on the property. Or, if the remainderman divorces, the spouse could claim part or all of the interest in the property.
3. Medicaid Ineligibility
Gifting real property while retaining life use, as with gifting any asset, can create issues with Medicaid eligibility. If John gifts property and retains a life estate, and then needs to apply for Medicaid within the five year period immediately following the transfer, the state will assess a penalty period based upon the value of the interest transferred to the remainderman.
A life interest has a value that is calculated based on the life expectancy of the holder. If property is sold during the lifetime of the life tenant, the proceeds are divided between the life tenant and the remainderman based on the value of their respective interests. If the life tenant is receiving Medicaid benefits, this will result in a period of ineligibility because the individual will likely have assets that exceed the limits allowed by Medicaid.
Is a life estate right for you?
A life estate is just one of the tools you can use to both protect your quality of life and your heirs’ inheritance. There are alternative solutions, some of which offer similar benefits without the risks. You might consider, for instance, transferring property into an irrevocable trust.
Making the right decision requires careful review of all the options in the context of your specific situation.
We can help you assess which estate planning strategy is right for you so that you can rest easy knowing that everything is taken care of in just the way you intended. Contact us to learn more.
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