The Listen to Lawrence Letter: Life Estates have Pros and Cons

November 10, 2023
November 9, 2023 • Volume 4 Issue 189
Life estates have pros and cons, but mostly cons…read on:

READER QUESTION:

Hi Lawrence,

My parents’ house is in a life estate with my sister and myself named as remaindermen. My mother is 88 years old. My father died in 2016.

In looking to the future, when my mother dies, will the property pass onto my sister and me without probate?

Also, if we sell the house upon my mother’s death, will we have to pay capital gains tax or is it considered inherited property?  Lastly, do you advise putting my mother’s house in a trust or leaving it as is, a life estate?

Any help is greatly appreciated. Thank you.

MY RESPONSE:

A life estate is created here when Mom transfers her home, by a new deed, to her child or children, while retaining the exclusive use and occupancy of the house for the rest of her life. Mom’s interest is called a life estate and the interest of the children is called the remainder interest. Five years after creating this the house is protected from Medicaid. Upon mom’s death, the life estate disappears and the children automatically own the home without probate. From a tax point of view, the children are deemed to inherit it and will receive a step up in tax basis, wiping out the capital gains tax when the property is sold soon after mom’s death.

As such a life estate can be an effective strategy to protect a house from Medicaid. But alas, it usually is a terrible strategy. The real problem is if the house were to ever be sold during mom’s lifetime. IRS tables will allocate the value of Mom’s life estate and the remainder interest, with the remainder interest being the much greater value. For example, if the house were to be sold while mom was in her 80s, it may turn out that her life estate is worth 5% and the remainder interest is 95%. Upon sale, 5% would then go back to mom (subject to Medicaid getting their hands on it) and 95% would have to go to the children (subject to capital gains tax as Mom’s $250,000 capital gain exclusion can not be used to offset the tax).

Therefore, we only recommend these life estates to clients who will swear in blood they will NEVER sell the house during their lifetime. An irrevocable trust solves these problems.

However, in this case, the life estate already exists. YIKES! Whether we should undo it or not is a question that would need to be discussed during a consultation. But if you never sell the house during Mom’s lifetime, you will avoid probate and eliminate the capital gain tax.

I hope this helps!  Pass this information along to your friends and family.

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As always, please send me your questions. If you are thinking about it, others are probably too, so my answers will no doubt help you and many others.

 

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