Rethinking the Value of Life Estates

By Ann Marie Carrozza, Huffington Post Financial Education, May 20, 2014

Life Estates were historically my "go-to" vehicle to help clients avoid both probate and long term care claims on the primary residence. This is no longer the case.

Background: Since the late 1990s, when many states enacted "Transfer on Death" legislation for brokerage accounts, most of a decedent's assets can now avoid going through probate at death. That is -- except for the primary residence. The Life Estate was long utilized to avoid probate by naming beneficiaries of a house directly on the deed. The life estate is created by transferring ownership of the house from "Mary Smith" to "Mary Smith, for life, Remainder Interest to Mary, Susie, and Johnny". In this arrangement, Mary owns the present and the kids own the future. Upon the death of Mary Smith, the remainder beneficiaries own the property immediately. The life estate also serves to protect the house against long term care claims, provided that it was created prior to the applicable Medicaid "look-back" period. This all sounds great, so why have I stopped using the life estate? Because in 10 out of 10 situations, I find that a properly drafted trust will accomplish one's planning goals more effectively.

Medicaid Look-Back: Prior to 2006, the so-called Medicaid look-back period for life estates was three years. This gave it an advantage over a trust, the look-back for which was always five years. Since 2006, however, the look-back period on everything is five years. Therefore, the life estate no longer enjoys this advantage.

Sale of House During Parent's Life: Both the trust and the life estate allow for the sale of the property during the parent's life. The problem with selling the house in a life estate is two-fold: The parent will receive a percentage of the sale proceeds outright. The acturarial value of the life estate (determined by reference to the 'life insurance tables') is payable directly to the parent. This leaves them with totally unprotected assets and the need to "start over" in terms of protecting this money. Moreover, if the parent is on Medicaid and in a nursing home at that point, the parent's 'life estate' portion of the sale proceeds must be turned over to Medicaid. As if this weren't bad enough, selling a home in a life estate will also deprive the family of "mom's" full $250,000 capital gains exclusion. This is because she only owned a percentage of the house ("the now") and therefore, isn't entitled to the full exclusion. By contrast, selling the house from within the trust, results in all of the sale proceeds being paid directly to the trust. These monies can then remain protected within the trust and invested in any asset class including a replacement residence for mom's use. The trust (if properly drawn) will also entitle the family to the full $250,000 capital gains exclusion).

Second Marriage Planning: The life estate is often employed to help clients balance the competing goals of protecting a surviving spouse against the desire to leave the primary residence to one's adult children of the first marriage. This life estate can be created in the will and reads as follows: "I leave my house to Jane, for her life, and then to Mary, Susie, and Johnny as tenants in common" This arrangement has intuitive appeal, but is flawed in several respects. Giving the surviving spouse lifetime ownership means just that. During all of the days of "Jane's" life, the children are unable to sell the house. This is true, even if Jane has moved away or is in a nursing home. A better result can be achieved by using a trust which gives Jane occupancy rights "until the earlier of her death, voluntary vacatur, stay in a nursing home, remarriage, or cohabitation with an unrelated person".

Other Assets: A life estate can only operate on real estate. A trust, on the other hand, can own every type of asset (including cooperative apartment shares). One typical elder law planning scenario is to transfer the home to a trust and leave the liquid assets in the parent's name. In the event of a long term care need, we can then transfer the liquid assets into the trust which already owns the house. Is there a new five year look-back on these just-transferred assets? Yes, but the look-back period for home care Medicaid in states such as New York, is only one month. Most people I know (including myself) would prefer to be at home in the event of a need for long term care.

The bottom line is that a properly drafted trust can offer all of the advantages (and more) of a life estate without the negatives.