Use of a Life Estate Should Be Rare
by Lawrence Eric Davidow

Saving the family home from the high cost of nursing homes and other long-term care expenses is high on the set of priorities of most middle-class seniors. Elder law attorneys have educated clients on the various solutions to this problem over the years. Perhaps the most popular legal solution to this problem is the creation of a life estate. It is also the most overused and usually inappropriate tool we have at our disposal. Its use should be rare.

A life estate is created by preparing a new deed. The deed conveys the property, in the usual manner, from the party of the first part to the party of the seond part. for example, Mom transfers her property to the names of her children. The only addition to this is that in the body of the deed, perhaps after the description of the property, the following language is inserted (or words to this effect):

THE PARTY OF THE FIRST PART HEREBY RETAINS A LIFE ESTATE
As is evident, the creation of a life estate is simple. It is a concept that all lawyers and clients can understand with ease. My contention, however, is that its simplicity breeds a climate for its inappropriate and overuse.

LIFE ESTATE'S BENEFITS
First, the good points. A transfer of real property by deed with a retained life estate can protect the property from having to be considered an available asset when seeking Medicaid coverage of long term care expenses. Subject to the look-back and transfer penalty rules, at a certain time in the future, the property will be protected.

A transfer of any non-exempt asset causes a Medicaid penalty, that is an amount of months in which the Medicaid applicant will not be eligible for Medicaid. Currently the formula to determine this, on Long Island, is, subject to a three year look-back (five years if the transfer is to an irrevocable trust) that the applicant will not be eligible for Medicaid for one month for each $9296 transferred.

One benefit of a life estate is that the value of the retained life estate itself is not considered for such transfer penalty purposes, thereby reducing the penalty period from the longer period based on the full value of the property.

The value of the retained life estate remains an asset of the Medicaid applicant, but it is at best an illiquid asset which Medicaid practically ignores. Medicaid will place a lien on this life estate value, but the lien is extinguished with the life estate itself upon the death of the life tenant.

Lawyers and their clients also love life estates because they keep seniors in control of their homes and allows them to retain all property tax exemptions.

Furthermore, upon the death of the life tenant, the remaindermen children now own the entire property, without probate, and they receive a step-up in tax basis, thereby eliminating all capital gains when the property is sold after their parent's death.

Life estates sound great. Our senior clients are in control, they have protected their homes from long term care, they have avoided probate and have preserved all tax benefits.
So what could possibly be wrong with the life estate technique in this context?

SELLING THE HOUSE
The problem with a life estate is that it can lead to disastrous consequences when the house is sold during the life of the life tenant.

Assuming that there is no concern with the need to obtain the consent of the remaindermen children to sell the property, there still exists tax and Medicaid problems with a sale of the senior's principal residence.

When a home is sold in a life estate situation, the sales proceeds are split between the life tenant and the remaindermen. The federal government laid the ground work for the proper percentages to apply in this context when it published Health Care Financing Administration (HCFA) transmittal #64. To give an example of the breakdown, if the life tenant were 76 years old at the time of the sale, 50 percent of the sales proceeds would inure to the benefit of the life tenant and 50 percent to the benefit of the remaindermen. Carrying this example further, what then are the tax and Medicaid ramifications of this sale?

Let's first discuss the tax ramifications, that being whether or to what extent the principal residence capital gain exclusion (IRS Section 121) can be applied to this transaction. The law permits a homeowner to exclude from capital gains $250,000, provided the homeowner owned and resided in the home for at least two out of the last five years. As applied in this case, a 76 year old life tenant would have only owned 50 percent of the property and thus would only be allowed to apply her $250,000 capital gains exclusion to the gains realized on such half. (As an aside, the IRS does not use the HCFA tables to determine the proper allocation between the life tenant and the reamindermen).

The remaindermen children, on the other hand, would not be allowed to apply any exclusion to the gain on their half, assuming they do not live with their parent(s). Therefore, a sale of a home in a life estate situation would cause capital gains to be paid on the remaindermen children's portion.

More sophisticated solutions involving irrevocable trusts solve this problem and should be offered to the clients as an alternative plan. The house can be transferred to an irrevocable grantor trust (pursuant to IRS Code Sections 674 and/or 675) and when sold during the senior's life, the full $250,000 capital gain exclusion could be applied to the entire property.

The Medicaid ramifications must also be considered. If the life tenant is not on Medicaid, then in the case we are discussing, 50 percent of the sales proceeds will be returned to the life tenant in an unprotected manner, necessitating a transfer (subject to lookbacks and penalties) all over again. Now that the client is older and perhaps less healthy, we are jeopardizing the assets, albeit half, all over again.

If the life tenant is on Medicaid, then Medicaid will have placed a lien on the life tenant's portion of the property which then must be satisfied at the closing. In this case we would simply lose 50 percent of the property.

In either case, if the property had been transferred originally to an irrevocable grantor trust, then the sales proceeds would have been payable to the trust, not returned to the senior. The trustee can then, if appropriate, purchase another home or otherwise invest the sales proceeds, without any further concern for the Medicaid system.

CONCLUSION
The bottom line is that a life estate poses tax and Medicaid problems during a sale of the property during the life of the life tenant. An irrevocable grantor trust will also keep the senior in control, protect their homes from long term care, avoid probate and preserve all tax benefits, but will allow the senior (or her trustee) to sell the house at any time during their life without tax and Medicaid issues. The use of a life estate ties the hands of a senior behind their backs because of the practical inability to sell the house during life.

When a lawyer approaches a client about this issue, the first question that should be asked is whether they are prepared to give up the right to sell their house during life. In those rare cases where the client is willing to give up all desires and rights to sell the house during life, the life estate is the appropriate tool to use.

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