Long-Term Care – Part IX (Protecting the Home cont’d)

The Greatest Financial Risk for Seniors: Paying for

Long-Term Care – Part IX (Protecting the Home cont’d)

Last month’s article concerned the advantages of protecting your house not by transferring the entire house out of your name, but rather by retaining a “life estate” for yourself and transferring only a “remainder interest” in the house. Doing this will protect your house while not affecting your standard of living; it will not expose your house to the risk of being sold because of things that might happen to your children (such as debt, divorce, disability, or death); and it will preserve a potential income-tax advantage for your children when the house is sold after your death.

This month’s article continues this discussion with a list of the advantages of transferring the “remainder interest” into an irrevocable trust rather than to your children directly.

Question: If the remainder interest in my house is held in an “irrevocable” trust, does that mean the house is locked up in the trust and so can’t be sold during my lifetime?

Answer: No, your house can be sold at any time, either during your lifetime or after your death, just as if you had not made this transfer. The only additional requirement would be that the trustee of your trust (typically one of your children) would need to sign the deed along with you (and your spouse if you are married). You sign the deed to convey your retained “life estate” interest, and the trustee signs to convey the “remainder interest.”

Question: Even so, wouldn’t it be simpler not to bother with an “irrevocable trust” at all and just have the children own the remainder interest?

Answer: No, just the opposite would be the case. Let’s use an example:

Suppose John and Mary Smith want to protect their house from a potential Medicaid Death Tax but they don’t want to use an irrevocable trust. So they transfer a remainder interest in their house directly to their four children: Roger, Alice, Tom, and Nancy.

Since John and Mary have retained a “life estate” for themselves, they get all of the advantages discussed in the prior articles in this series. But here are some of the problems that can arise when the house is later sold because John and Mary did not use an irrevocable trust.

  • First of all, in order to convey good title to the property when the house is sold, not only would all four of their children need to sign the deed, but their spouses as well. And they all must sign before a notary public. At best this would be an inconvenience in having to get all of these signatures, especially if the children are scattered around the country (or, with some of our client families, around the world).

But there are potentially more serious difficulties:

    • For example, suppose son Roger had lost his job and so has been unable to pay his creditors and has now filed for bankruptcy? Because his parents had kept a life estate in their house, Roger’s creditors could not force the house to be sold. But once the house is voluntarily sold, they can certainly go after Roger’s share of the sales proceeds.
    • What if Alice is going through a contentious divorce at the time the house is sold? Will her husband demand additional compensation as part of the divorce settlement in exchange for agreeing to sign off on the deed?
    • What if Tom is disabled as the result of an automobile accident and now receiving Medicaid? Part of the sales proceeds (25% of the remainder interest) will be going directly to him, and he will then be ineligible for Medicaid until this money is spent down.
    • What if Nancy died before the house was sold? An estate would then have to be opened for her and a Personal Representative appointed in order to have someone with the legal authority to sign the deed transferring her one-fourth of the remainder interest. (And the extra expense and delay of opening an estate would probably have been of no benefit for Nancy’s family – if she had owned everything jointly with her husband, there would have been no need to open an estate for her otherwise.)
  • Finally, last month’s article pointed out a potential income-tax advantage for the children in having the parents retain a life estate and transfer only a remainder interest in their house. Using our example, suppose John and Mary had retained a life estate interest in their house but transferred the remainder interest directly to their four children rather than into an irrevocable trust. After the death of both John and Mary, Pennsylvania inheritance tax will be owed on the full value of the property. But paying this tax eliminates any built-in capital gain. Because the Pennsylvania inheritance-tax rate for property going to children is 4.5%, while capital gains are typically taxed at 15%, this can often mean an overall tax savings for the children.

But suppose John died but the house was sold during Mary’s lifetime. Because Mary owns the life estate and is still living, there would be no inheritance tax to pay. But there will probably be capital gains tax for the children to pay. Suppose John and Mary purchased this house 40 years ago for $20,000 and that this is their “cost basis” in the house, and after John’s death it sold for $140,000. The sale price ($140,000) less Mary’s cost basis ($20,000) is $120,000 of “capital gains” and is income to Mary and her children.

  • This is not going to be a problem for Mary. Since the house has been her primary residence for at least two of the past five years, she has a capital gains income-tax exemption of $250,000.
  • But what about her children? Assuming Mary was 82 when the house sold, then her life-estate interest would be 40%, and so the children’s “remainder interest” would be 60%. That means they would have $72,000 of capital gains income ($120,000 x 0.6 = $72,000). At a capital gains rate of 15%, that’s $10,800 of income tax that the children will owe the IRS.

Now, the point of this entire discussion is that all of these potential problems could have been avoided if John and Mary had transferred the remainder interest in their house into an irrevocable trust rather than directly to their children.

  • There would have been only one additional person who had to sign the deed, the trustee, rather than eight additional people – the four children and their spouses.
  • The children’s share of the sales proceeds would go directly into a trust account and so be protected from their creditors (including a divorcing spouse) and would not affect Tom’s Medicaid eligibility.
  • And Mary’s $250,000 tax exemption would apply to the entire $120,000 of capital gains, so her children would not owe any income tax to the IRS as a result of this sale.

Next month’s article will conclude this series on protecting the house with a discussion of the advantages of having the “remainder interest” in your house go into an irrevocable-trust if you later want to sell your house and purchase another house.

Note: Working with the long-term care system we have in this country, seniors and their families need to understand that despite the restrictions in the Medicaid law, it is almost never too late to protect part or your remaining assets, even when facing an immediate crisis and with no advance planning. Whether you are 75 years old and living in your own home, or have an 85-year-old spouse in a nursing home, there are steps you can be taking now to preserve part – and often a very significant part – of your life savings otherwise at risk of being spent on your nursing care. But it is more true than ever that “time works against you.” Every day of delay in a crisis can result in $275 or more of irretrievable loss, so it is important to contact a knowledgeable and experienced elder law attorney for advice sooner rather than later.

Kemp Scales is now retired, but elder-law attorney Schellart Los continues to serve clients throughout western Pennsylvania from offices in Erie and Titusville. She can be reached toll-free at (888) 827-2788 or by e-mail at schelly@losscaleselderlaw.com. The Law Offices of Schellart Joyce, LLC has an Internet presence at www.losscaleselderlaw.com.