Irrevocable Trusts and Life Estates

Although there is some fresh snow on the ground here in New York, we hope you are as excited for Spring as we are. In the meantime, in this newsletter, we will be discussing the dilemma many people encounter when deciding between an Irrevocable Trust or a Life Estate in their Estate Plan.

Many people hear the words "Irrevocable Trust" and think that the irrevocable nature of the instrument requires inflexibility and rigidity, or that they will lose control over their assets. This is a common myth.

An irrevocable trust may enable an individual to retain a significant degree of control over assets during life while providing for protection from creditors and reducing tax liability for the person's heirs following death. Putting assets into an irrevocable trust also may help to reduce the risk that a child's creditor or ex-spouse will take the assets while the parent is alive.

Concerns Over Costs of Long-Term Care

One very big concern that has been growing recently is the possibility that a person's hard-earned assets will have to be spent down to cover the costs of necessary long-term medical care, leaving nothing to transfer to the healthy spouse, children, or other loved ones. Long-term care costs have been rising, and the law allows Medicaid to look back up to five years to determine if any assets have already been transferred.

For that reason, it is important to come up with a strategy to protect these assets while a person is healthy before the need for long-term medical care arises. The longer that a person waits to protect assets, the more likely it is that the assets will not be protected.

Irrevocable Trusts in an Estate Plan

One way for people to avoid having their remaining assets used to pay for long-term medical care is to place their assets in an irrevocable trust as part of a comprehensive estate plan.

Consider a hypothetical married 70-year-old couple in good health with two children. They own a home worth approximately $500,000 and have approximately $300,000 in other assets. The couple wants to protect their assets from being taken to pay creditors, including long-term care providers, and to avoid the costs associated with probate.

One solution for this couple may be to transfer some or all of their assets to an irrevocable trust. The husband and wife would be the grantors to the trust and would choose an independent trustee to manage the trust during their respective lifetimes. The trustee would have the ability to pay the necessary expenses from the trust assets. Using an independent trustee can give a person a much greater sense of safety than transferring assets outright to children as gifts.

In this example, when the husband and wife pass away, any assets which were put into the irrevocable trust are not included in the person's estate for the calculation of Medicaid assistance, an estate tax, or probate. The state can only lien assets included in the probate estate to reimburse Medicaid for long-term medical care it provided.

The probate estate includes assets owned individually at the time of death. Assets owned by an irrevocable trust are not owned in the individual's name so they are not part of the probate estate. Therefore, these assets are not subject to Medicaid's estate recovery provision. That means, ultimately, that assets in the trust will be preserved for the person's heirs.

Life Estates in an Estate Plan

Many couples also consider using a life estate to protect their homes, rather than transferring property into a trust. Creating a life estate requires executing a deed that transfers ownership of the property to the grantee, yet gives the owners the legal right to reside at the property as long as either of them lives.

Who Owns The Property In A Life Estate?

A “life estate” is a type of joint property ownership and refers to property that a person owns and uses within their lifetime. The person who owns the property may also be referred to as a “life tenant”. They may share the ownership of the property with another person who is known as the “remainderman”.

A life tenant cannot sell or mortgage a property without agreement from the remainderman -- they may only live or use the property. The remainderman automatically receives the title to the property when the life tenant dies. With a life estate, the probate process may be avoided and it helps make the process of dividing up property after a person’s death easier.

Benefits Of A Life Estate

This approach can ultimately protect homeowners from having the property taken to pay for long-term care. However, it can also create huge unnecessary problems. If the children experience financial difficulty during the life of the parents, creditors may be able to put a lien on the residence. They could not force a foreclose on the lien while the parents are alive, but the existence of the lien would still cause problems for the children when the property transfers to them following the death of both parents.

Additionally, if a child gets divorced, the house in a life estate may also be considered a marital asset. This means ex-spouse could get half of the property.

Life Estate Creates Conflicts of Interest and Capital Gains Issues

A life estate also means that the parents cannot sell the home without the consent of all children that hold the remainder interest. A child that wants to keep the home in the family can stop the parents from selling. If the parents sell after transferring the property to their children, the children would be assessed a capital gains tax.

Consider the hypothetical couple with two children and a house worth $500,000 and the couple bought it for just $100,000. If the parents transfer the property to their children, retaining a life estate, and later decide to sell, all four individuals are considered owners. The children would be assigned approximately 50% of the cost basis in the property and approximately half of the sale proceeds.

That means that each child would be assumed to have earned an income of $100,000 from the sale, minus $25,000 of the cost basis, which leaves a capital gain of $75,000. Each child would then have to pay close to $20,000 in capital gains taxes on the parents' home.

This unjust outcome becomes even more unfair when the capital gains tax exclusion is factored into the equation. The law allows a capital gains tax exclusion of up to $500,000 for a married couple on a person's primary residence.

That means, if the parents lived in the property and used it as their home for at least two years during a five-year period before the sale, they are allowed to exclude up to $500,000 of the sale's proceeds from being taxed.

Since each parent's share of the sale proceeds is only $100,000, they pay no taxes - yet their children get a tax bill solely because the parents transferred the property to them before selling it. Also bear in mind that, had the parents not transferred the property to their children, their capital gains would have been $400,000, and no capital gains taxes would have been owed.

When looking at these numbers, it is clear that transferring the property to the children and retaining a life estate may not benefit the children. It may also cause strife if the children refuse to sell because of the potential tax liability. Remember that the parents cannot sell without the children's agreement.

Irrevocable Trust Benefits vs. a Life Estate

If the couple decided instead to transfer the home to an irrevocable trust, they could still retain a joint life estate. However, the remainder interest would belong to the trust. In this scenario, the parents could sell the home without their children's consent and without facing the capital gains tax issues in the prior example.

The couple would be considered the owners for income tax purposes and could take the full benefit of the capital gains exclusion following a sale. They would pay no capital gains tax. In addition, creditors of the children would have no access to the property during the parents' lives and the trust would give the couple some protection against their own creditors.

Potential Capital Gains Benefits

The estate inclusion also provides a significant tax benefit known as a step-up in basis for capital gains tax purposes. If a parent transfers an asset that has increased in value, the parent's cost basis carries over to the child.

That means, when the asset is eventually sold, the child will be assumed to have taken the asset at the same price as the parents and required to pay capitals gains taxes on the full increase in value.

Similar to our previous example, if the parents obtained their stock at $100,000 and transferred it as a gift to the children with a value of $500,000, the children are given a cost basis of $100,000. If they later sell the stock for $500,000, the children will realize and recognize a $400,000 capital gain, which translates to approximately $100,000 in federal capital gains tax liability.

Instead, if the parents transferred the stock to an irrevocable trust, the stock would be included in the gross estate of the parents and given a step-up in basis upon their death. The step-up in basis means the stock is valued as of the date of the parent's death, not at the time of purchase.

Similarly, if the parents put their home into an irrevocable trust with a fair market value of $500,000, the children's cost basis will also be $500,000. Therefore, if the children sold the home soon after their parents' deaths, there would be little or no capital gains to be taxed. As far as the children are concerned, this is a much more desirable outcome.

This benefit is not available to individuals who transfer assets outright to their children as gifts.

In conclusion, an irrevocable trust is a valuable tool that allows parents to transfer assets in a manner that will provide protection from their creditors, including the costs of long-term care, and their children's creditors (including ex-spouses) while allowing the parents to benefit from the assets comprising the trust during their lives. In addition, this trust provides some estate and income tax benefits for both the parents and their heirs.