You own your home and you want to protect your home from future long term care costs. In that case, you might consider transferring ownership of your home to your children, or to a trust for their benefit, while retaining a “Life Estate.” Your other options, in addition to a Life Estate Deed, might include (1) doing nothing; (2) gifting your home to your children, outright; (3) transferring your home to an Intentionally Defective Grantor Trust and retaining the right to use and occupy the property.
If you do nothing and keep the property in your name, you will continue to have full access to and control over your residence, but it will not be protected from your future long term care costs. Additionally, the property will be included in your estate at your death. Including your residence in your estate at death is desirous if the property is highly appreciated because, at death, your heirs will receive a “step-up” in cost basis at your passing. For example, if you paid $40,000 for your home and spent $20,000 on improvements to the property, your basis in the property would be $60,000. If the property is worth $150,000 at your passing and your children inherit it from you, they will receive a step-up in cost basis to the property’s fair market value at death (in this example, $150,000). Therefore, if they thereafter sell the property, they would only realize a taxable capital gain on any appreciation over the fair market value at your death. Of course, if you require long term care and the house is not protected because you continue to own it, you may ultimately need to sell the property to pay for your care costs and, therefore, there will have been no gain to protect at your death.
If you gift your residence to your children outright, then your children will be the owners of the property, not you. This arrangement is riddled with issues. First, if you gift the property to your children, they assume your cost basis in the property. In the above example, your children’s cost basis in the property would be only $60,000 and the fair market value would be $150,000. Your children would receive no step-up in cost basis at your death because you would no longer be the owner of the property. Thus, if your children sell the property (during your life or after your death), they would trigger a capital gains tax on the difference between your basis ($60,000) and the sales price ($150,000). Next, if you gift your home to your children, you are no longer the owner of the property. Therefore, you are not in control of it and could be forced out. Additionally, you can no longer claim the Homestead Rebate or a Senior Citizen’s Deduction. Also, your property is at risk to your children’s creditors. Or, if a child of yours predeceases you, their interest in your home may (depending on how the deed was titled) pass to their spouse or children, in accordance with the child’s estate planning documents. Finally, any monies you pay toward household expenses, if not structured properly, could be characterized as gifts from you to your children by Medicaid. Gifting a residence to children will protect the property from long-term care costs only if you do not need to apply for Medicaid benefits within five (5) years from the date the property is transferred out of your name.
Next, you might consider creating an Intentionally Defective Grantor Trust (“IDGT”) and retaining the right to use and occupy the property. Here, you would reserve the right to use and occupy the property, but if you vacate the property or pass away, the property would revert to the IDGT. If the property was sold during your lifetime, no capital gains tax would be due because the gain would be taxed to you by virtue of the IDGT and, assuming you can satisfy the Personal Residence Exclusion, no capital gains tax would result. 26 U.S.C.§ 121. Also, if you pass away, the property will be included in your estate thanks to the IDGT and your trust beneficiaries (children) would receive a step-up in cost basis. Also, by virtue of the “use and occupancy” language on your new deed, you would retain all of the benefits and burdens of home ownership. Thus, you would be responsible for all expenses, but you would also still be able to claim the Homestead Rebate and any Senior Citizen’s Deduction. That said, to enter into an IDGT and a use and occupancy deed can be complicated and expensive. However, if you think there is a likelihood that the property may be sold during your lifetime and the property has appreciated, this may be your best option so that you can avoid the capital gains tax at the time of sale. Gifting a residence in this fashion will protect the property from long-term care costs only if you do not need to apply for Medicaid benefits within five (5) years from the date the property is transferred.
Finally, one of the most often used tools in our estate and asset protection toolbox is the Life Estate Deed. With a Life Estate Deed, you convey ownership of your residence to your children (or to a trust for their benefit) and you reserve a Life Estate in the property. Assuming you do not need Medicaid assistance within five (5) years from the date on which the property is transferred in this fashion, you are able to protect the full value of your home from long term care costs. By keeping a Life Estate in the property, during your lifetime, you remain responsible for all costs associated with the property, and you receive all of the benefits of home ownership. The tax rules associated with a Life Estate are summarized as follows:
1. Homestead Tax Rebate. Since you are reserving a Life Estate in the
property and you are responsible for the taxes, the maintenance and the upkeep of the property, you would be entitled to continue to receive any homestead tax rebate that New Jersey allows under the provisions of N.J.A.C:18:12-7.1(b)8i.
2. Senior Citizen’s Deduction. Since you have retained a life interest in the property and you are paying the real estate taxes, you are entitled to continue to receive any Senior Citizen’s Deduction which you might now be receiving. N.J.A.C. 18:14-1.1 and N.J.A.C. 18:14-2.8.
3. Income Tax Deduction for Real Estate Taxes. Since you are an owner of the property by virtue of your life interest and you are making payment of the real estate taxes, you may continue to deduct those taxes on your federal income tax return I.R.C. §164(a); Reg. §1.164-1(a).
With a Life Estate, if you die owning the property, then at the time of your death the property will be included in your estate and your heirs will receive a step up in basis. However, if you sell the property during your lifetime, then you will receive a portion of the proceeds based on your life interest. The life interest of a 86 year old, for example, will be approximately 35%. Therefore, if the property is sold, the “Life Tenant” will receive 35% of the proceeds and the heirs (or the Trust) will receive the remaining 65%. Thus, a capital gains tax would be due on the portion of the gain allocable to the 65%, but not on the 35% passing back to the Life Tenant. Furthermore, each year that the Life Tenant gets older, the percentage that the Life Tenant will receive will decline and the percentage that will go to the heirs will increase. The current capital gains rate is 15%. If the property has not appreciated, then there would be no capital gains due on the sale. On the other hand, if the Life Tenant’s cost basis is substantially less than the fair market value of the property and the property is sold during the Life Tenant’s death, then a capital gains tax will have to be paid on the portion that passes into the Trust.
Also with a Life Estate, the property is protected from your children’s creditors and no one can kick you out of your home! If you pass away with a Life Estate, the full value of the property is included in your estate. Having the property included in your estate is a wonderful thing if your property is highly appreciated because, at your death, your heirs will receive the property with a basis equal to the property’s fair market value at your death. Thus, any capital gains tax on a future sale will be eliminated or significantly reduced.
In short, a Life Estate Deed is a highly efficient way to try to protect your residence from future long term care costs, while protecting your interest in the property and ensuring that the property receives a step-up at your death. The potential negative of a life estate is if the property is highly appreciated and is sold during the lifetime of the Life Tenant, a capital gains tax will be imposed on a portion of the sales proceeds.
If you would like to discuss a Life Estate, or a use and occupancy deed and IDGT, please contact us here or give us a call at (856)489-8388.
