PROTECTING
Many older individuals worry that their homes may be at risk if they need nursing home care. For many families the home is the largest and most valuable asset that they own. In addition, there is tremendous emotional attachment to the physical place that has served to nurture the hopes and dreams of the whole family. A common misconception is that putting a child s name on the house will protect it. And it is a common practice to add one or more children as joint owners. However, there are tax characteristics and other issues with transfers that make planning for the best result anything but simple. Why does the home need protection? For many families home is the largest most valuable asset they own. As we grow older the chances of becoming incapacitated grow rapidly. A particular concern for families is the extraordinary costs of nursing homes. In Rhode Island the average monthly cost of a nursing home is $8,643. At this rate most families go broke very quickly. Once an individual has spent all of his or her resources Medicaid will pay the bill. In Rhode Island Medicaid is administered by the Department of Human Resources and individuals must comply with the state regulations in order to qualify. The state regulations in turn must comply with federal law. Until February of 2006, neither state nor federal law forced an individual to sell the home in order to qualify for Medicaid. To the contrary, in most circumstances the home was protected under Medicaid law as long as the Medicaid recipient was alive. However, under the Deficit Reduction Act of 2005 a limit on home equity is now imposed. Thus, for elders today there are two circumstances which require special planning and attention. The first problem arises when an individual has received Medicaid and dies. When that happens the state is required to place a lien against the estate of the deceased recipient. If an individual has received Medicaid and dies with the home in his or her name, the home will be part of the probate estate and will be subject to the state s lien for recovery of the benefits paid. In Rhode Island the lien only reaches an individual s probate estate and it does not attach if there is a surviving spouse. The second problem arises when an individual owns a home with equity above the state s limits. In 2006 Rhode Island imposed a limit on equity of $500,000 while Massachusetts imposed a limit of $750,000. These limits are adjusted annually for inflation. www.orsonandbrusini.com (401) 223-2100 (401) 861-3103 fax 144 Wayland Ave, Providence, RI 02906 2
PLANNING FACTORS. These circumstances have created a major focus for elder law attorneys: to protect the home from an estate recovery lien, and to assure that home equity does not disqualify single individuals. The first goal can be accomplished by positioning the home outside of the individual s probate estate and thus outside of the reach of the state s recovery. The second goal can be accomplished with many of the same planning strategies. In planning with individuals and families it is essential to look at the impact of any transfer in light of several significant factors. 1 Estate and Gift Tax Any transfer of an interest that results in a gift in excess of $14,000 to one individual donee will be a taxable gift under federal law and must be reported on a federal gift tax return. There are inherent disadvantages to lifetime gifts. When an individual makes a gift the recipient of the gift takes the donors basis. Basis is an income tax characteristic upon which subsequent capital gain is calculated. Most often your basis in an asset is what you paid for it plus any capital improvements. If you paid $10,000 for your property twenty years ago and you sell it for $110,000, you have $100,000 in capital gain and a $20,000 tax bill at the 20% rate. If you paid $10,000 for your property and you give it to your child, your child takes your basis and will have the tax bill upon the sale. While a gift results in this disadvantage, there are great income tax advantages to inheriting property. When you inherit property under a will or a trust you get what is called a stepped-up basis. In our example, if your house is worth $110,000 when you die and you leave it to your child in a trust, your child gets a basis equal to the fair market value at your date of death. Thus, upon the sale of the property at $110,000 there is no capital gain, no tax due and significant savings to your child. In the past, estate tax was seldom a factor in Medicaid planning. However, with the real estate values in some Rhode Island communities so high, and a Rhode Island exemption of just over $920,000 it may be a factor to consider. That is because when an individual transfers property to another but retains control of the property the entire value will be www.orsonandbrusini.com (401) 223-2100 (401) 861-3103 fax 144 Wayland Ave, Providence, RI 02906 3
included in his estate. This will be true even if all or a portion of the property was given away. Poorly planned gifts could result in the value being included in an estate twice. 2 Capital Gains Tax One of the most important tax attributes of your home is the exclusion from capital gain that your principal residence receives. In 1997 the rules were liberalized and now allow exclusion of $250,000 for individuals and $500,000 for married couples. In order to qualify for the exemption you must own and occupy the residence as your principal residence for any two of the last five years. Any transfer of property to a child should be considered carefully. 3 Transfer Issues and Control Any transfer of property to a child should be considered carefully. If your child has creditor problems, those creditors will be able to reach your assets. If your child has marital problems, your assets could become subject to divorce claims. Your child, or your child s spouse may have plans for your assets that you didn t anticipate. For all of these reasons you must act carefully if you are putting your assets in the hands of your child with the belief that they will be there for you if you need them. Tax deductions and property tax exemptions must also be considered in light of any proposed transfers. Most importantly, how does the transfer affect control of the property? Will you be able to sell it without the permission of your children? Can your children sell it without your permission? How does a transfer to children affect your ability to live in the home for as long as you wish? 4 Transfer Penalties The Medicaid rules provide for certain penalties when a person transfers property for less than fair market value. The penalty imposed on prohibited transfers is a period of time in which the State will not pay for the nursing home. The old rule was that the penalty period www.orsonandbrusini.com (401) 223-2100 (401) 861-3103 fax 144 Wayland Ave, Providence, RI 02906 4
could not exceed three years. However, present law provides a look back of five years for all transfers. This means that when you apply for Medicaid you must report any transfers during the five year look back period. Not every prohibited transfer will incur the maximum penalty period. And, the exact penalty period depends upon the value of the property transferred. The length of the penalty is determined by dividing the value transferred by the average monthly cost of a nursing home and is calculated in months. To illustrate, if you transfer your house to your daughter at a time when it s fair market value is $100,000 and the average monthly cost of a nursing home is $8,643, you will incur a penalty period of 11.5 months. Under the old law an individual could make a transfer in order to start a penalty period running. For instance, if you gave away $100,000 in January of 2004 the penalty period would begin to run on January 1, 2004. As long as you stayed out of the nursing home until April 2005, the transfer would not create a problem for you. The Deficit Reduction Act of 2005 (DRA) makes the same scenario very problematic. Under the DRA the penalty period does not begin to run until you are in the nursing home, are otherwise eligible and have applied for Medicaid. This means that you are sick, out of money and you have to file an application. Now, if you give away $100,000 and enter the nursing home 11.5 months later, and you are otherwise eligible for Medicaid, you will not qualify for nursing home payments until another 11.5 months have passed. PLANNING STRATEGIES. 1 Transfer Penalties A life estate deed is a deed in which the parent conveys the home to the children but retains the right to live in the home during his or her life. This strategy is a very popular method to position the home outside of the probate process. Like a joint tenancy, the property passes outside of the probate estate. Because the parent retained a life estate the children will receive a stepped-up basis in the property when the parent dies. A life estate deed is a deed in which the parent conveys the home to the children but retains the right to live in the home during his or her life. www.orsonandbrusini.com (401) 223-2100 (401) 861-3103 fax 144 Wayland Ave, Providence, RI 02906 5
In addition, the parent maintains the property tax deductions and tax exemptions. A transfer pursuant to a life estate deed will incur a penalty period in case the owner should get sick and need to go into a nursing home. However, the penalty period is not based upon the whole value of the property, but rather only a portion of the value. A transfer subject to a life estate is considered a transfer of the remainder interest for Medicaid purposes. The value of the remainder interest is a portion of the whole value based upon the age of the parent. For instance, a parent who is 90 years old will give away a larger portion of the value than someone who is 20 years old. The shorter penalty period is often an important factor in planning. To illustrate, suppose a parent who is 75 years old owns a home worth $100,000 and transfers it to her daughter retaining a life estate. Federal tables provide that the parent has given away 50% of the value or $50,000. That results in a penalty period of 5.7 months as opposed to11.5 months in the example above. For someone who is already in a nursing home this shorter penalty period may allow them significant savings. However, the life estate deed has certain disadvantages as well. Because the parent only owns a portion of the property following the transfer to the children, any sale may be subject the property to capital gains tax. The portion owned by the parent will be exempt from capital gains tax (up to the limits) as the primary residence. However, unless the children also live in the property their portion of any gain will be taxed. For this reason the life estate deed may not be a good strategy if the parent is contemplating a sale of the property. The life estate deed also results in significant loss of control of the property, and any future sale would require the cooperation of the children. For individuals who have many children and want an equal disposition of the estate the deed can be inconvenient and inefficient. For instance, having four, five, or six names on the deed can cause additional problems. If one of the children dies before the parent that interest may have to be probated. Another difficulty with a life estate deed occurs in a family in which one of the children has special needs or a disability. In those situations you do not want to give the child an interest that will disqualify the child from benefits or make the property subject to control by a person of questionable competence. www.orsonandbrusini.com (401) 223-2100 (401) 861-3103 fax 144 Wayland Ave, Providence, RI 02906 6
In families that are less than harmonious you do not want to create an opportunity for conflict. Planners have been quite creative in getting around some of the problems associated with the life estate deed. For those concerned with the possible capital gains tax on sale that problem can be solved by conveying the remainder to a certain type trust for the children rather than the children personally. When this is done correctly the IRS says the trust is the same as the parent, and the trust qualifies for the exemption from capital gains tax just as the parent would. This approach is also useful when a child is disabled or when there are a number of children. Post DRA the life estate deed will continue to be a very valuable planning tool. Consider the healthy 75 year old individual who owns a beautiful home in Newport or Narragansett or Barrington. If the equity is above $500,000 it can be reduced with a life estate deed. Notwithstanding, the transfer issue, if an individual with a home equity of $600,000 were to transfer a remainder interest in the home to a grantor trust, after the transfer she will own a life estate valued at $300,000. Thus, if an application for Medicaid were appropriate at some time in the future the home would continue to be an exempt non-countable asset. 2 Irrevocable Trust Under both federal and state law a parent can create what is called an irrevocable income only trust with his or her own assets and those assets will be protected from being spent on a nursing home. These trusts must be irrevocable, which means that once the trust is established it cannot be changed. The parent can retain any income earned by the trust and can retain a life estate in the home transferred to the trust. However, the parent must give up the right to take back any trust property. If the irrevocable income only trust is written correctly it will have all of the tax benefits available to the parent as an individual. The parent will retain eligibility for exclusion from capital gain for the whole property. The property will receive a stepped-up basis upon the death of the parent. The parent can be the trustee of the trust If the irrevocable income only trust is written correctly it will have all of the tax benefits available to the parent as an individual. www.orsonandbrusini.com (401) 223-2100 (401) 861-3103 fax 144 Wayland Ave, Providence, RI 02906 7
and sell the property without the consent or cooperation of the children. The trust can provide for special needs or supplemental needs trusts continuing for children who may need them. And, the trust can fairly distribute an estate to a number of children efficiently without subjecting the parent s property to the creditor or divorce claims of the children. Use of the irrevocable income only trust requires the parent to relinquish all rights to the principal or the underlying trust property. In other words the parent must be content to leave the property in the trust. Establishing such a trust may also incur longer penalty periods as the value of the transfer is based on the fair market value of the whole property. That means that if the home has significant value you may incur lengthy penalty periods. This strategy is one that is helpful to healthy people and typically is not used in a crisis situation. Once an individual has established an irrevocable income only trust, if the residence is transferred to the trust and sold the proceeds stay in the trust. The trust can purchase a new home and the parent will get any income earned by the proceeds, but again, the parent is prohibited from taking distributions of principal. This can be a superior feature because, unlike the life estate deed, the income only trust can continue to protect cash and investments if the house is sold. These assets are protected once the penalty period expires. An example will help to illustrate the point. Mary Jones is 75 years old and in good health. Her home is worth $350,000. She has another $250,000 in investments. She has four children, one of whom is bi-polar and frequently unemployed. Mary creates an irrevocable income only trust on December 1, 2010 and transfers her home to it on the same day. The trust provides that she has the right to live in the house for her life and that she has the rights to any income earned by the trust. She has now incurred a penalty period of 50 months. If Mary should need a nursing home within five years of establishing the trust how will she deal with the penalty period of 50 months? Well, let s assume she has income of approximately $3,000 and she is admitted to a nursing home that cost $8,000 per month. This leaves a shortfall of $5,000 per month. Upon The trust can provide for special needs or supplemental needs trusts continuing for children who may need them. www.orsonandbrusini.com (401) 223-2100 (401) 861-3103 fax 144 Wayland Ave, Providence, RI 02906 8
admission to the nursing home, Mary could purchase an annuity that will pay her just under the $4,900 for 50 months. The purchase of the annuity will convert countable assets into an income stream without penalty (if properly structured). She then applies for Medicaid and is found otherwise eligible. During the 50 months her income and the annuity payments cover almost all of her expenses and her children make up the difference. When the annuity is depleted and the transfer penalty has expired, Mary will qualify for Medicaid payments to the nursing home. Let s suppose that Mary stays healthy for five years. In 2015 Mary decides that the home requires too much care and she wants to move into assisted living. Mary sells the home and receives $450,000 in proceeds. Those proceeds earn $9,000 a year at 2% interest. Mary uses the income to pay for the assisted living and as of December 1, 2015 she knows the principal will pass to her children regardless of whether she ever receives Medicaid. In addition, Mary knows that upon her death one fourth of the trust principal will be held in a supplemental needs trust for her daughter with bi-polar disease. The supplemental needs trust will provide her daughter an equal share in the estate without jeopardizing any benefits she may be receiving. CONCLUSION. A major focus of elder law attorneys is to assist families with planning to protect the home. Planning for the principal residence needs to incorporate consideration of many important factors. Families will enjoy significant benefits with good quality planning. The informed family will quickly see that simple solutions do not require a great deal of analysis but may fall far short of providing the best results. Orson and Brusini offers customized solutions to individual issues. Our lawyers take a pragmatic approach to solving problems, helping our clients plan ahead by providing practical advice that comes from years of experience and insights that go beyond their legal training. Make an appointment today! Call (401) 223-2100 or visit www.orsonandbrusini.com Estate Planning Elder Law Medicaid Planning Special Needs Trusts Trusts Probate Special-Needs Planning Tax Planning www.orsonandbrusini.com (401) 223-2100 (401) 861-3103 fax 144 Wayland Ave, Providence, RI 02906 9