Gifting Your House with a Life Estate vs. Medicaid Trust
I recently published an article called “Don’t Gift Your House To Your Children” which highlighted the pitfalls of gifting your house to your kids versus setting up a Medicaid Trust to own your house, as an asset protection strategy to manage the risk of a long-care care event taking place in the future. That article prompted a few estate attorneys to reach out to me to present a third option which involves gifting your house to your children with a life estate. While the life estate does solve some of the tax issues of gifting the house to your kids with no life estate, there are still issues that persist even with a life estate that can be solved by setting up a Medicaid trust to own your house.
I recently published an article titled “Don’t Gift Your House To Your Children” which highlighted the pitfalls of gifting your house to your kids versus setting up a Medicaid Trust to own your house, as an asset protection strategy to manage the risk of a long-care care event taking place in the future. That article prompted a few estate attorneys to reach out to me to present a third option which involves gifting your house to your children with a life estate. While the life estate does solve some of the tax issues of gifting the house to your kids with no life estate, there are still issues that persist even with a life estate that can be solved by setting up a Medicaid trust to own your house.
In this article, I will cover the following topics:
What is a life estate?
What is the process of gifting your house with a life estate?
How does the life estate protect your assets from the Medicaid spend-down process?
Tax issues associated with a life estate
Control issues associated with a life estate
Comparing the life estate strategy to setting up a Medicaid Trust to own your house
3 Asset Protection Strategies
There are three main asset protection strategies when it comes to protecting your house from the Medicaid spend-down process triggered by a long-term care event:
Gifting your house to your children
Gifting your house to your children with a life estate
Gifting your house to a Medicaid Trust
Gifting Your House To Your Children
Gifting your house outright to your children without a life estate is probably the least advantageous of the three asset protection strategies. While gifting your house to your kids may be a successful strategy for getting the house out of your name to begin the Medicaid 5-Year Lookback Period, it creates a whole host of tax and control issues that can arise both while you are still alive and when your children inherit your house after you pass away.
Note: The primary residence is not usually a countable asset for purposes of Medicaid BUT some counties may place a lien against the property for any payments that Medicaid makes on your behalf for long-term care services. While Medicaid can’t make you sell the house while you are still alive, once you pass away, Medicaid may be waiting to recoup the money they paid, so your house ends up going to Medicaid instead of passing to your children.
Here is a quick list of the issues:
No Control: When you gift your house to your kids, you no longer have any control of that asset, meaning if the kids wanted to, they could sell the house whenever they want without your permission.
Tax Issue If You Sell Your House: If you gift your house to your kids and then you sell your house while you are still alive it creates numerous issues. First, from a tax standpoint, if you sell your house for more than you purchased it for, your children have to pay tax on the gain in the house. Normally, when you sell your primary residence, a single filer can exclude $250,000 of gain and a married filer can exclude $500,000 of gain from taxation. However, since your kids own the house, and it’s not their primary residence, you lose the exclusion, and your kids have to pay tax on the property as if it was an investment property.
No Step-up In Cost Basis: When you gift an asset to your kids while you are still alive, they inherited your cost basis in the property, meaning if you paid $100,000 for your house 30 years ago, their cost basis in your house is $100,000. After you pass away, your children do not receive a step-up in cost basis, which means when they go to sell the house, they have to pay tax on the full gain amount of the property. If your kids sell your house for $500,000 and you purchase it for $100,000, they could incur a $60,000+ tax bill.
Life Estate Option
Now let’s move on to option #2, gifting your house to your kids with a life estate. What is a life estate? A life estate allows you to gift your house to your children but you reserve the right to live in your house for the rest of your life, and your children cannot sell the house while you are still alive without your permission.
Here are the advantages of gifting your house with a life estate versus gifting your house without a life estate:
More Control: The life estate gives the person gifting the house more control because your kids cannot make you sell your house against your will while you are still alive.
Medicaid Protection: Similar to the outright gift your kids, a gift with a life estate, allows you to begin the Medicaid 5-year look back on your primary residence so a lien cannot be placed against the property if a long-term care event occurs.
Step-up in Cost Basis: One of the biggest advantages of the life estate is that the beneficiaries of your estate receive a step-up in costs basis when they inherit your house. If you purchase your house for $100,000 30 years ago but your house is worth $500,000 when you pass away, your children receive a step-up in the cost basis to the $500,000 fair market value when you pass, meaning if they sell the house the next day for $500,000, there are no taxes due on the full $500,000. This is because when you pass away, the life estate expires, and then your house passes through your estate, which allows the step-up in basis to take place.
Lower-Cost Option: Gifting your house to your children with a life estate only requires a simple deed change which may be a lower-cost option compared to the cost of setting up a Medicaid Trust which can range from $1,500 - $5,000.
Disadvantages of Life Estate
However, there are numerous disadvantages associated with life estates:
Control Problems If You Want To Sell Your House: While the life estate allows you to live in the house for the rest of your life, you give up control as to whether or not you can sell your house while you are still alive. If you want to sell your house while you are still alive, you, and ALL of your children that have a life estate, would all have to agree to sell the house. If you have three children and they all share in the life estate, if one of your children will not agree to sell the house, you won’t be able to sell it.
Tax Problem If You Sell It: If you want to sell your house while you are still alive and all of your children with the life estate agree to the sale, it creates a tax issue similar to the outright gift to your kids without a life estate. Since you gifted the house to your kids, they inherited your cost basis in the property and would not be eligible for the primary gain exclusion of $250,000 / $500,000, so they would have to pay tax on the gain.
One slight difference, the life estate that you retained has value when you sell the house, so if you sell your house for $500,000, depending on the life expectancy tables, your life estate may be worth $50,000, so that $50,000 would be returned to you, and your children would receive the remaining $450,000.
Medicaid Eligibility Issue: Building on the house sale example that we just discussed, if you sell your house, and the value of your life estate is paid to you, if you or your spouse are currently receiving Medicaid benefits, it could put you over the asset allowance, and make you or your spouse ineligible for Medicaid.
Even if you are not receiving Medicaid benefits when you sell the house, the cash coming back to you would be a countable asset subject to the Medicaid 5-Year Lookback period, so the proceeds from the house may now become an asset that needs to be spent down if a long-term care event happens within the next 5 years.
Your Child’s Financial Problems Become Your Problem: If you gift your house to your children with a life estate, similar to an outright gift, you run the risk that your child’s financial problems may become your financial problem. Since they have an ownership interest in your house, their ownership interest could be exposed to personal lawsuits, divorce, and/or tax liens.
Your Child Predeceases You: If your child dies before you, their ownership interest in your house could be subject to probate, and their ownership interest could pass to their spouse, kids, or other beneficiaries of their estate which might not have been your original intention.
Medicaid Trust
Setting up a Medicaid Trust to protect your house from a long-term care event solves many of the issues that arise compared to gifting your house to your children with a life estate.
Control: You can include language in your trust documents that would allow you to live in your house for the rest of your life and your trustee would not have the option of selling the house while you are still living.
Protection From Medicaid: If you gift your house to a grantor irrevocable trust, otherwise known as a Medicaid Trust, you will have made a completed gift in the eyes of Medicaid, and it will begin the Medicaid look back period.
Step-up In Cost Basis: Since it’s a grantor trust, when you pass away, your house will go through your estate, and your beneficiaries will receive a step-up in cost basis.
Retain The Primary Residence Tax Exclusion: If you decide to sell your house in the future, since it’s a grantor trust, you preserve the $250,000 / $500,000 capital gain exclusion when you sell your primary residence.
Ability to Choose 1 or 2 Trustees: When you set up your trust, you will have to select at least 1 trustee, the trustee is the person that oversees the assets that are owned by the trust. If you have multiple children, you have the choice to designate one of the children as trustee, so if you want to sell your house in the future, only your child that is trustee would need to authorize the sale of the house. You do not need to receive approval from all of your children like you would with a life estate.
Protected From Your Child’s Financial Problems: It’s common for parents to list their children as beneficiaries of the trust, so after they pass, the house passes to them. But the trust is the owner of the house, not your children, so it protects you from any financial troubles that could arise from your children since they are not currently owners of the house.
Protect House Sale Proceeds from Medicaid: If your trust owns the house and you sell the house while you are still alive, at the house closing, they would make the check payable to your trust, and your trust could either purchase your next house, or you could set up an investment account owned by your trust. The key planning item here is the money never leaves your trust. As soon as the money leaves your trust, it’s no longer protected from Medicaid, and you would have to restart the Medicaid look back period.
A Trust Can Own Other Assets: Trusts can own other assets besides real estate. A trust can own an investment account, savings account, business interest, vehicle, and other assets. The only asset a trust typically cannot own is a retirement account like an IRA or 401(k) account. For individuals that have more than just a house to protect from Medicaid, a trust may be the ideal solution.
Comparing Asset Protection Strategies
When you compare the three Medicaid asset protection options:
Gifting your house to your children
Gifting your house to your children with a life estate
Gifting your house to a Medicaid Trust
The Medicaid Trust tends to offer individuals a higher degree of control, flexibility, tax efficiency, and asset protection compared to the other two options. The reason why people will sometimes shy away from setting up a trust is the cost. You typically have to retain the services of a trust and estate attorney to set up your trust which may cost between $1,500 - $5,000. The cost varies depending on the attorney that you use and the complexity of your trust.
Does A Trust Have To File A Tax Return
For individuals that are using the Medicaid trust to protect just their primary residence, their only cost may be to set up the trust without the need for an annual trust tax filing because a primary residence is usually not an income-producing property. However, if your trust owns assets other than your primary residence, depending on the level of income produced by the trust assets, an annual tax filing may be required each year.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Don’t Gift Your House To Your Children
A common financial mistake that I see people make when attempting to protect their house from a long-term care event is gifting their house to their children. While you may be successful at protecting the house from a Medicaid spend-down situation, you will also inadvertently be handing your children a huge tax liability after you pass away. A tax liability, that with proper planning, could be avoided entirely.
A common financial mistake that I see people make when attempting to protect their house from a long-term care event is gifting their house to their children. While you may be successful at protecting the house from a Medicaid spend-down situation, you will also inadvertently be handing your children a huge tax liability after you pass away. A tax liability, that with proper planning, could be avoided entirely.
Asset Protection Strategy
As individuals enter their retirement years, they become rightfully more concerned about a long-term care event happening at some point in the future. The most recent statistic that I saw stated that “someone turning age 65 today has almost a 70% chance of needing some type of long-term care services at some point in the future” (Source: longtermcare.gov).
Long-term care is expensive, and most states require you to spend down your countable assets until you reach a level where Medicaid starts to pick up the tab. Different states have different rules about the spend-down process. However, there are ways to protect your assets from this Medicaid spend-down process.
In New York, the primary residence is not subject to the spend-down process but Medicaid can place a lien against your estate, so after you pass, they force your beneficiaries to sell the house, so Medicaid can recoup the money that they paid for your long-term care expenses. Since most people would prefer to avoid this situation and have their house passed to their children, they we'll sometimes gift the house to their kids while they're still alive to get it out of their name.
5 Year Look Back Rule
Gifting your house to your kids may be an effective way to protect the primary residence from a Medicaid lien, but this has to be done well before the long-term care event. In New York, Medicaid has a 5-year look back, which means anything that was gifted away 5 years before applying for Medicaid is back on the table for the spend down and Medicaid estate lien. However, if you gift your house to your kids more than 5 years before applying for Medicaid, the house is completely protected.
Tax Gifting Rules
So what’s the problem with this strategy? Answer, taxes. When you gift someone a house, they inherit your cost basis in the property. If you purchased your house 30 years ago for $100,000, you gift it to your children, and then they sell the house after you pass for $500,000; they will have to pay tax on the $400,000 gain in the value of the house. It would be taxed at a long-term capital gains rate, but for someone living in New York, tax liability might be 15% federal plus 7% state tax, resulting in a total tax rate of 22%. Some quick math:
$400,000 gain x 22% Tax Rate = $88,000 Tax Liability
Medicaid Trust Solution
Good news: there is a way to altogether avoid this tax liability to your beneficiaries AND protect your house from a long-term care event by setting up a Grantor Irrevocable Trust (Medicaid Trust) to own your house. With this solution, you establish an Irrevocable Trust to own your house, you gift your house to your trust just like you would gift it to your kids, but when you pass away, your house receives a “step-up in cost basis” prior to it passing to your children. A step-up in cost basis means the cost basis of that asset steps up the asset’s value on the day you pass away.
From the earlier example, you bought your house 30 years ago for $100,000, and you gift it to your Irrevocable Trust; when you pass away, the house is worth $500,000. Since a Grantor Irrevocable Trust owned your house, it passes through your estate, receives a step-up to $500,000, and your children can sell the house the next day and have ZERO tax liability.
The Cost of Setting Up A Medicaid Trust
So why doesn’t every one set up a Medicaid Trust to own their house? Sometimes people are scared away by the cost of setting up the trust. Setting up the trust could cost between $2,000 - $10,000 depending on the trust and estate attorney that you engage to set up your trust. Even though there is a cost to setting up the trust, I always compare that to the cost of not setting up your trust and leaving your beneficiaries with that huge tax liability. In the example we looked at earlier, paying the $3,000 to set up the trust would have saved the kids from having to pay $88,000 in taxes when they sold the house after you passed.
Preserves $500,000 Primary Residence Exclusion
By gifting your house to a grantor irrevocable trust instead of your children, you also preserve the long-term capital gain exclusion allowance if you decide to sell your house at some point in the future. When you sell your primary residence, you are allowed to exclude the following gain from taxation depending on your filing status:
Single Filer: $250,000
Joint Filer: $500,000
If you gift your house to your children and then five years from now, you decide to sell your house for whatever reason while you are still alive, it would trigger a tax event for your kids because they technically own your house, and it’s not their primary residence. By having your house owned by your Grantor Irrevocable Trust, if you were to sell your house, you would be eligible for the primary residence gain exclusion, and the trust could either buy your next house or you could deposit the proceeds to a trust account so the assets never leave the trust and remain protected for the 5-year lookback rule.
How Do Medicaid Trusts Work?
This article was meant to highlight the pitfall of gifting your house to your kids; however, if you would like to learn more about the Medicaid Trust solution and the Medicaid spend down process, please feel free to watch our videos on these topics below:
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
