Life Estate Deed Income Tax Issues
Clients come to us with a variety of real estate issues in a medicaid-planning context: Howto handle homestead with equity over $552,000? How to plan so that a vacation home avoids Medicaid estate recovery?, and more. The real estate in question, may be titled in fee simple, have multiple owners with rights of survivor ship, or be subject to a life estate. I have never recommended a regular life estate for Medicaid or estate planning purposes, instead I see significantly more benefits and fewer drawbacks to utilizing an enhanced life estate deed (also known as a “lady bird deed”).
What is a life estate?
The life estate tenant conveys their property but retains a life-time right to use and occupy the property. Upon the death of the life tenant, full ownership transfers to the individual(s) who have the remainder interest (also called remainder man). Medicaid treats this conveyance as a transfer for value (and thus, if done within 5 years) will subject the life tenant/Medicaid applicant to a penalty period. Another disadvantage is that the life tenant must obtain permission from the remainder man to convey the property(these disadvantages are non-issues with lady-bird deeds). To determine the value of the interest conveyance one must know the value of the property and the age of the life tenant.
Determining Value Attributable to the Life Tenant and Remainder man
The older the life tenant, the shorter their life expectancy. The shorter the life expectancy, the shorter period of time the life tenant is expected to be able to use and enjoy the property. This equates to a lower value to the life tenant and higher valued interest attributable to the remainder man (thus increasing the divestment subject to penalty). The value of the life estate is found by going to the Life Estate and Remainder Interest Table here.
The value of the life estate is found by taking the value of the property and multiplying it by the life estate factor (a.k.a. life estate rate).The value of the remainder is found by taking the resulting life estate value and deducting it from the value of the property (or multiplying the value of the property by the remainder rate). Again, it is the remainder rate value that determines the divestment subject to penalty.
For example, if a home is valued at $200,000, and the life tenant is 85 years old, (per the life estate and remainder interest table, there is a life estate factor of .35359 and a remainder factor of .64641. That means the value of the life estate to the life tenant is: $70,718 and the value to the remainder man is: $129,282 (you’ll notice the value of both numbers adds up to$200K). If Medicaid was needed within 5 years of recording the life estate deed, this would result in $129,282 transfer penalty. If this is done outside of the five-year look back period, then, of course, there would be no penalty.
But recently, someone came to me who was a remainder man on a previously-executed ordinary life estate deed and wanted to know the tax consequences to selling the home prior to the life tenant passing away and the impact it would have should the life tenant require Medicaid ICP in the future.
- DISCLAIMER: My initial reaction to the tax-consequences portion of the question was, “I don’t know, let me look into it.” I am not too proud to admit when I need to speak to a colleague to answer someone’s question. I am not a CPA nor do I have an LLM in tax. I do not render tax advice and always tell my clients that they need to confirm any tax consequences for any planning we do with their CPA or tax attorney. I spoke to a CPA friend of mine who gave me information that sounds accurate but I was provided with very general information and cannot confirm its accuracy. Do not relay on this blog article (or any blog article) when making planning decisions. Meet with a tax professional!
Facts: The home was purchased for $100,000 many years ago and would probably sell for about $200,000 now. The life estate was recorded over five years ago (this is a good fact because an ordinary life estate would result in a gift-penalty subject to the Medicaid five-year lookback period). Similar to above, let’s assume the life tenant is 85 years old.
What are the income tax consequences on sale of real property subject to a life estate?
First, it should be noted that if the life tenant passed away, upon filing the death certificate, title would pass to the remainder man with a “step-up in tax basis,” which means that upon sale of the house the capital gains tax would be significantly lower. If the property was bought for $100,000 but worth$200,000 at time of life estate tenant’s death and it sold for $205,000,capital gains taxes are only paid on the $5,000 excess after the "step up."
But when a home is sold prior to the death of the owner, there is no “step up in basis” and capital gains taxes are paid on the original purchase price value of the home. However, the IRS provides an exemption amount (currently$250,000 for single and $500,000 for married owners of real property). This personal residency tax exemption is available if the owner(s) have lived in the subject real property for 2 of the last 5 years. It essentially means that no capital gains is paid on the first $250,000 of gains for a property owned by a single individual.
But, only the life tenant (original owners) get the value of the exemption. The value of the life tenant’s personal capital gains tax exemption, if the property is sold during their lifetime, is proportional to their ownership interest per the life estate and remainder interest tables on the date of the sale (see above). This exemption is not a benefit enjoyed by the remainder man – they get no tax exemption upon the sale of the property during the life tenant’s life. So any capital gains taxes due would likely come from the remainder owner’s proportionate share of proceeds.
However, since financial responsibility for taking care of a sick parent is usually born by their children (who are also likely the remainder man in an ordinary life estate) the capital gains taxes would likely be more than offset by the savings of being able to shelter the proceeds and allowing Medicaid to pay for the parent's long-term care.