Does It Fit Into Your Estate Planning?
Have you thought about transferring your home into a co-ownership, so the person you’d like to have your home certainly will have it after you pass away? Whether you want to leave your house to an adult child or children, or to another relative or friend, a life estate might be right for you.
It works like this. Owner A., called the life tenant, can live in the house for life. Then, Owner B. gets the “remainder” of the ownership. So, a deed stating the property goes “to Ann Smith for life, then to Ashley Smith as the remainder” vests Ann with a life estate, and Ashley with the remainder. Ann signs the deed, and has it recorded in the county where the house is. Voilà! The home avoids probate, ownership is transferred into both names, yet Ann has a lifelong place to live on her terms.
Without Ann’s express consent, Ashley may not move in during Ann’s lifetime. Ann is free to make upgrades to the home, or even use it for rental income.
But Ann becomes, in effect, the steward of the property for the future benefit of Ashley. Ann must cover all the bills: utilities, insurance, property taxes and repairs. Ann also gets the applicable tax breaks, and the homestead exemption for a primary residence, in states that offer it.
Averting Life Estate Pitfalls; Considering Alternatives
Of the two co-owners, it’s presumed that Ann, the life tenant, will outlive the deed’s beneficiary, Ashley. But what if Ashley unexpectedly dies first?
Should that happen, the property will pass to the Ashley’s heirs. In other words, if you establish a life estate for yourself, intending to pass ownership to a particular person, you could inadvertently end up co-owning with that person’s heirs instead. It’s something to think about before creating a life estate, as it will be too late to change once the joint ownership exists.
What can the life estate holder do to avoid this inflexible aspect of the life estate deed?
Lady Bird Deeds
Check for enhanced life estate deeds in states that allow them. In contrast to the standard life estate, the enhanced form, known as a lady bird deed, lets the life tenant mortgage or sell the property, change the beneficiary, or revoke the deed. The involvement of the co-owner (or co-owner’s spouse) is not necessary. Because it’s not an actual, final conveyance during life, an enhanced life estate also avoids gift tax. Texas, Vermont, Florida, Michigan and West Virginia allow lady bird deeds to shield your home value, and other states have common-law provisions or allow for trusts with similar effects.
Transfer on Death Deeds
Your state may have created other deed forms that bypass probate yet allow you to keep control over your property during life. The transfer on death deed (beneficiary deed) lets you name a beneficiary. You can revoke or change this whenever you wish while you’re living. Upon your passing, your house will automatically pass to the designated beneficiary on the deed.
Wills and Trusts
If your state offers neither of the above, you could consider creating a life estate through a will or trust. A revocable living trust can pass the house to your beneficiary, without probate, after your passing. Or you could bequeath the house through your will.
A few final words on potential hitches with the life estate deed. Because it creates a co-ownership, the joint owners can impact each other’s financial lives. The life tenant can’t lose homeownership rights, but could wind up thrust into the middle of a remainder holder’s divorce case or credit-related court proceeding.
Understanding Life Estates and Medicaid Recovery
When someone holds a home as a life tenant, the asset they co-own won’t disqualify the life tenant from Medicaid. So, in some states, homeowners set up life estates to obtain financial support to enter a care home if they need to. This may spare beneficiaries from estate recovery, in which adult children of deceased homeowners must pay their parents’ Medicaid bills when taking title to their properties.
State law differ on Medicaid estate recovery. But note: If the state places Medicaid lien on the life estate home, it will attach only to the life estate. The bulk of the home’s value has already been passed to the remainder beneficiary.
☛ Important note: Revocable living trusts do not shield an estate from Medicaid recovery. Read more here on Medicare and Medicaid liens, and speak with an estate planning professional to choose the best instrument for your personal set of circumstances.
Medicaid administrators look back five years to find out if the applicant conveyed any assets to relatives or friends. If the house was conveyed in that five-year period through a life estate, the deed will be void. The house will be liquidated upon its owner’s death to reimburse Medicaid. So, assume that creating a life estate deed means you may not apply for Medicaid within five years. An estate lawyer can offer important tools and guidance if the owner anticipates the need for residential care before that five-year period is up.
Selling the Life Estate Property
What if the co-owners later decide they’d like to get out of the life estate? The way out is to sell the property.
As long as the life tenant is alive, neither co-owner may sell the property unless they jointly agree to do so. If our life estate holder Ann wishes to sell, and Ashley’s on board with the plan, these life estate co-owners will share the proceeds, in amounts calculated by the IRS [PDF]. The IRS accounts for the current interest rates; and a life tenant who still has a long life expectancy would get more value back from the sale than an older life tenant.
Here, as the property is sold while Ann is living, Ashley may be paying some rather high taxes on appreciation of the home’s value — that is, capital gains taxes. But what if Ann passes away, and Ashley later decides to sell? Ashley may have the benefit of a stepped-up tax basis, typically resulting in lower capital gains taxes.
Important note: Be sure your financial planning accounts for any liens that will need paying off when selling the property.
After the Life Tenant Passes Away: Claiming the Remainder
What happens after Ann, the life tenant, passes on? There is no need to consult Ann’s will regarding the house, and no need put it through probate. Together with Ann’s death certificate, the original life estate deed proves Ashley’s new ownership status. Ashley files the documents with the county recorder of deeds, and receives the house title.
Though the property bypasses probate, it is part of Ann’s taxable estate. Your tax specialist can help you anticipate the deed’s potential impact on your gift tax exclusions and estate tax before you create a life estate.
Most people are under the financial threshold and need not worry about federal estate taxes. Yet the state might apply estate taxes at certain wealth brackets. State exemptions are generally lower. If they apply, Ashley could face a hefty estate tax bill.
Important note: An agent of the homeowner must apply the highest level of care when working with elderly homeowners to plan what happens to their assets after they pass. The validity of a deed becomes vulnerable wherever undue influence could potentially occur. A party holding the power of attorney must record the POA instrument, and carefully adhere to the original owner’s estate plan.
Being Prepared for Shared Ownership
Forming a life estate is a matter of creating the right deed. Then, the original owner can enjoy living in the home undisturbed, yet the property is already passed along — effectively and firmly — to a designated beneficiary. If multiple life tenants or multiple remainder holders will be on the deed, then vesting the deed is an important as creating the life estate itself.
Life estate deeds avoid probate, and they are uncomplicated to create. Yet in exchange for this convenience, the life estate tenant must share key ownership rights with a co-owner. When you’re a life tenant, anything significant you might want to do with your ownership interest will now need your co-owner’s consent. And once this deed is done, it’s not easily undone. So, discuss your own situation with your attorney or Medicaid planner.
As you can see, potential impacts of creating a new deed are more complicated than the deed itself. In the case of a life estate, a local estates and trusts lawyer can provide invaluable advice for the soon-to-be life tenant and beneficiary.
Internal Revenue Service Publication 1457: Annuities, Life Estates & Remainders; and as linked.