Use of a Life Estate Should be Rare – Part 3

November 14, 2004

SELLING THE HOUSE The problem with a life estate is that it can lead to disastrous consequences when the house is sold during the life of the life tenant.

Assuming that there is no concern with the need to obtain the consent of the remaindermen children to sell the property, there still exists tax and Medicaid problems with a sale of the senior’s principal residence.

When a home is sold in a life estate situation, the sales proceeds are split between the life tenant and the remaindermen. The Federal government laid the ground work for the proper percentages to apply in this context when it published Health Care Financing Administration (HCFA) transmittal #64. To give an example of the breakdown, if the life tenant were 76 years old at the time of the sale, 50 percent of the sales proceeds would inure to the benefit of the life tenant and 50 percent to the benefit of the remaindermen. Carrying this example further, what then are the tax and Medicaid ramifications of this sale?

Let’s first discuss the tax ramifications, that being whether or to what extent the principal residence capital gain exclusion (IRS 121) can be applied to this transaction. The law permits a homeowner to exclude from capital gains $250,000, provided the homeowner owned and resided in the home for at least two out of the last five years. As applied in this case, a 76-year-old life tenant would have only owned 50 percent of the property and thus would only be allowed to apply her $250,000 capital gains exclusion to the gains realized on such half. (As an aside, the IRS does not use the HCFA tables to determine the proper allocation between the life tenant and the remaindermen).

The remaindermen children, on the other hand, would not be allowed to apply any exclusion to the gain on their half, assuming they do not live with their parent(s). Therefore, a sale of a home in a life estate situation would cause capital gains to be paid on the remaindermen children’s portion.

More sophisticated solutions involving irrevocable trusts solve this problem and should be offered to the clients as an alternative plan. The house can be transferred to an irrevocable grantor trust (pursuant to IRS code 674 and/or 675) and when sold during the senior’s life, the full $250,000 captial gain exclusion could be applied to the entire property.

Next we’ll discuss the Medicaid ramifications that must be considered with a life estate.

Next week we’ll explain the benefits of the life estate.