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Real Estate: Life Estate or Irrevocable Trusts

Many of our clients call the office and ask whether Lake Shore Legal can draft a trust to place a piece of property into. When the client is asked what the purpose of placing the property into the trust is, they almost always say “so that the 60-month MassHealth look back clock can start.” However, when we sit down with the client and gather more information, most clients are shocked to find out that there are an abundance of other considerations to take into account before deeding real estate into an irrevocable trust. Some of these items include whether the real estate is income producing, control of the property, tax basis in the property, tax consequences of selling the property while the client is alive, and complexity.

This blog will briefly discuss the pros and cons of transferring real estate into an irrevocable trust and the pros and cons of transferring real estate to another individual but maintaining a life estate.

Life Estate

A life estate is the transfer of the homeowner’s (life tenant) remainder interest in the principal residence to an individual(s) (the remaindermen) where the homeowner will retain many of the tax benefits conferred on the homeowner. A life estate transfer will remove the entire value of the home from potential estate tax recovery by MassHealth following the life tenant’s death.

Life Estate Pros

The most significant advantage of transferring property while retaining a life estate is that of tax basis in the property. When the life tenant transfers title of the property to the remaindermen these remaindermen take the life tenant’s then current tax basis in the property. This is due to the fact the remaindermen are ultimately being gifted the property. However, since the life tenant retains the benefit of the property during the remainder of the life tenant’s life (the life estate), upon the life tenant’s death, the remaindermen of the property actually receive a stepped-up basis in the property to the date of death value. Therefore, when the property is sold after the life tenant’s passing, any tax on gain from the sale is based upon the sale proceeds that exceed the property’s date of death value. This can have significant tax benefits to the remaindermen.

Another substantial benefit is that property subject to a life estate is not a probate asset. The property will transfer to the named remaindermen in the deed upon the passing of the life tenant. MassHealth can technically lien the life tenant’s life estate interest in the property during the life tenant’s life. This lien can be enforced if the property is sold during the life tenant’s life, however, if the property is not sold until after the life tenant has passed away the lien is unenforceable against the property. MassHealth can only recover against the life tenant’s probate estate, which would not include the real estate property.

Life Estate Cons

Upon transferring an interest in the property to the remaindermen, the life tenant has given up certain powers concerning the real estate. The most significant power given up, is the ability to unilaterally sell the real estate. If the life tenant wishes to sell the real estate, the life tenant must get the permission of the remaindermen. If the remaindermen are unwilling to permit the sale to occur, the life tenant cannot unilaterally sell the property.

A sale of the real estate also has tax consequences not only to the life tenant but to the remaindermen named in the deed. Every homeowner has a $250,000 exclusion of gain on the sale of a principal residence. If the property is sold during the life tenant’s life time, the $250,000 exclusion would only apply to the proceeds allocable to the life tenant’s interest in the property. The remaining interest in the property, that held by the remaindermen, would not be subject to an exclusion. The remaindermen would then have to pay tax on the remainderman’s interest in the sale proceeds.

Irrevocable Trusts

Transferring ownership of real estate into an irrevocable income only trust is a very common means of protecting real estate from MassHealth liens. Such a transfer is subject to a sixty month look back. Similar to a life estate transfer, there are pros and cons that must be considered.

Irrevocable Trusts Pros

A transfer to an irrevocable income only trust is usually made by the homeowner (grantor) for the benefit of third party beneficiaries. These beneficiaries are the ultimate recipients of the property upon the conclusion of the trust. The grantor would not have access to the principal of the trust, the real estate, but the net income would be payable to the grantor.

Income only trusts can be very useful if the real estate being transferred is not only the principal residence of the grantor but also a rental income source. The grantor would give up ownership of the property to the trust, but would be entitled to the net income of the trust.

A specific trust that has been approved by the Massachusetts Supreme Judicial Court is a trust called an Intentionally Defective Irrevocable Grantor Trust. This trust is drafted in such a manner that the real estate is placed into an irrevocable trust and the grantor loses all rights to the real estate. However, the grantor is allowed the net income from the trust. This net income is taxed on the grantor’s individual tax return. Ultimately there is no change in the taxation of the rental income to the grantor. The income, gains, losses, deductions and other credits flowing from the trust assets are attributed to the grantor and not to the trust or the trust’s beneficiaries.

The biggest benefit of this trust is that for tax purposes the grantor is treated as the owner, even though for MassHealth the grantor is treated as having no interest in the real estate after the 60 months look back period. Upon the grantor’s death, the trust beneficiaries would get a stepped-up basis in the property to the date of death value. This type of trust is very useful, very popular, and very grantor friendly.

There is no gift tax owed on the transfer into this type of trust due to the fact the grantor has retained tax rights which makes the grantor’s transfer into the trust an incomplete gift.

Irrevocable Trusts Cons

A grantor gives up all control of property once transferred into an irrevocable trust. The grantor cannot dictate how the property is utilized, cannot request a trustee to sell the property, nor challenge the trustee’s usage of the property. The grantor for all purposes has transferred all ownership interest in the property to the trust.

Selling the property while held by a trust can be another issue. If the trustee decides to sell the house while the trust is in grantor-trust status, up to $250,000 of the gain will be excluded from tax if the grantor meets the use and ownership requirements under IRC § 121(a). If the requirements are not met then the proceeds from a sale would be taxed at the trust level which is a significantly higher tax rate than that of an individual.

Because the grantor has retained certain benefits of the property it is included in the grantor’s estate for federal and Massachusetts estate tax purposes. Therefore, if a secondary goal of the transferring the property into a trust is to reduce the grantor’s overall estate value, an Intentionally Defective Irrevocable Grantor Trust would not be beneficial. However, a normal irrevocable trust would and could satisfy this secondary goal.

In most circumstances Lake Shore Legal will communicate with the grantor’s CPA or tax preparer prior to a transfer into an irrevocable trust, so that all parties agree on the tax consequences.

Lake Shore Legal

The thought process of protecting the personal residence is complicated. For most individuals the personal residence is the biggest and most important asset that they own. Instead of allowing MassHealth to disqualify you from coverage, or placing a lien upon your property, contact Lake Shore Legal. Our attorneys possess the estate planning and tax knowledge necessary to properly analyze your unique situation and explain all available options, include each option’s pros and cons. Lake Shore Legal can be contacted at info@lakeshorelegalsolutions.com or (508) 943-7800.

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