LIFE ESTATE DEED WITH POWER OF APPOINTMENT
Should I Give My Home To My Children?
We are often asked whether it is a good idea for parents to transfer their home to their children so that the children can keep the home if the parents need nursing home care. The answer is that this can be a good idea if it is done correctly, but there are a number of complex issues involved, and the situation can actually be made worse if the transfer is done wrong.
Five Year Look Back for Medicaid:
One issue with transferring the house from parents to children is that the transfer must be made well in advance of the parents' need for nursing home care. The current look back period for Medicaid qualification to pay for nursing home care is five years. This means that if you gift the home less than five years before needing nursing home care, then there will be a penalty period imposed before Medicaid will pay for the nursing home. The length of this penalty period depends upon the value of the house and it is still possible to achieve some savings even if the house is transferred within the five years. There are also certain exceptions from this penalty, such as for transfers to a caregiver child or a disabled child. Nevertheless, it is better to avoid these complications by making the transfer at least five years in advance.
Capital Gains Tax:
A second issue with transferring the house is the loss of a potentially significant capital gains tax advantage. The capital gains tax is a 20 percent tax (15 percent federal and about 5 percent for New Jersey), that is paid on the difference between what you paid for something and what you receive when you sell it. If the parents have owned the house for a long period of time, this tax can be substantial. If the parents sell the house during their lifetime, then they are exempt from this tax on up to $250,000 worth of gain for each parent, assuming the house was their principal residence for at least two out of the five years before the sale and that certain other requirements are met. If the parents give the house to their children, then the children would have to meet this principal residence requirement to avoid the capital gains tax when the house is sold. However, if the children wait to receive the house until after the parents have died, then they pay a capital gains tax when the house is sold on the difference between the sale price and value of the house at the date of death (instead of what the parents actually paid for the house). Usually, this means a zero tax if the house is sold within a year after the parents death. Therefore, unless the children are planning on living in the house for at least two years before selling, the capital gains tax may be substantially increased if the house is gifted during the parents' lifetime.
Loss Of Control And Children's Creditors:
A third issue with transferring the house to the children is the loss of control of the house and the risk from children's creditors. If the parents transfer the house outright to the children, then the children own the house. The children do not have to allow the parents to live in the house and can actually sell the house and take the proceeds. If any of the children get into financial difficulty, then their creditors may be able to force the sale of the house. If any of the children get divorced, then their spouse's may end up owning part of the house. If the parents are receiving property tax deductions for being senior citizens or veterans, then these benefits will be lost. Some of these issues can be addressed by making a written agreement between the parents and the children and possibly the children's spouses as well, but many of these problems are unavoidable with an outright transfer of the house.
Life Estate Deed:
One way to avoid most of these problems is to transfer a remainder interest to the children with the parents retaining a life estate. This is referred to as a Life Estate Deed. Basically, this means that the parents retain ownership during their lifetime (the life estate), but the children will own the house upon the parents death (the remainder interest). Under current New Jersey Medicaid regulations, the value of the life estate is not counted as a resource and is also not subject to estate recovery upon the parents death. So basically, for Medicaid purposes, the life estate portion just disappears. As to the remainder interest, the value of this portion is a transfer so the Life Estate Deed should still be done at least five years in advance. For tax purposes, the entire property is considered to be still owned by the parents so the capital gains tax is eliminated upon the parents deaths. Also, any property tax deductions for the parents will still be available. This type of Deed also avoids probate and the property passes automatically to the children upon the death of the parents. There is some risk that the children's creditors could put a lien on the remainder interest, but they should not be able to force a sale during the parents' lifetime.
Capital Gains Tax On Lifetime Sale:
There are still some significant problems which remain with a Life Estate Deed which occur if the house is sold during the parents' lifetime. In this situation, the parents would be entitled to only the value of the life estate and the children would receive the value of the remainder interest. This would make the children's portion subject to potential claims from children's creditors and all the other potential problems discussed above. Also, the parents would only be entitled to a principal residence exemption from the capital gains tax on the value of the life estate. The children would have to pay the capital gains tax on the value of the remainder interest. Roughly, the value of the remainder interest is a percentage equal to the parents age. For example, for an 80 year old parent, the remainder interest would be about 80 percent and the life estate would be about 20 percent. Thus, we still would have a potentially substantial capital gains tax problem.
Life Estate Deed With Power Of Appointment:
These last problems can be avoided by adding additional language to the Life Estate Deed reserving to the parents what is called a Power of Appointment to change the remainder beneficiaries. In addition to retaining the Life Estate, the parents retain the power to change their mind about which children will get the house. Grandchildren or other heirs can also be included. Because the parents can change their mind about which children are entitled to the remainder interest, they can avoid any lifetime problems that they may have with any particular child by removing that child's remainder interest, but include a provision in their Wills to return that remainder interest so that all children receive the house. Also, because the parents have retained so much control over the remainder interest, for capital gains tax purposes, the remainder interest should be treated as still owned by the parents and thus receive the full principal residence exemption. This means that for Medicaid purposes, the parents do not own the house, but for all the good tax benefits, the parents do own the house.
Risks Of Life Estate Deed and Power of Appointment:
Based on all of the above, it would seem that a Life Estate Deed with a Power of Appointment would a good planning tool quite often. However, there are a number of issues with a Life Estate Deed and with the Power of Appointment that can make it not such a good idea. Before using this type of Deed all of these risks should be understood.
Power of Appointment May Be Invalidated:
One risk with the Life Estate Power of Appointment Deed is that we cannot guarantee that it will continue to work. There has been at least one case in Wisconsin that invalidated the Power of Appointment. However, it is our belief that this Power of Appointment will be valid in New Jersey if the issue is ever litigated here. It is also possible that if a child is in bankruptcy, the bankruptcy rules may prohibit removing that child's interest through the Power of Appointment.
Power of Appointment May not Work for Tax Purposes:
With regard to the capital gains tax exemption applying to the remainder interest, this theory has yet to be approved by the IRS in any published opinion. We have obtained that exemption on a few occasions. However, this was only for each of those situations and another reviewer could disallow the exemption. Also, the IRS could issue regulations or obtain a Court ruling that the exemption is now allowed.
Limitation on Financing:
Banks will not loan money secured on a Life Estate Deed, even if all of your children signed off on their interest. This would mean, for example, that you would not be able to use a reverse mortgage to help pay for private aids to allow you to stay in the house if you need that level of care. You might be able to find what is called hard money lender who might be willing to issue a loan, but this would be at a significantly higher interest rate. Therefore, if you need finance the property, you would need to transfer it back to yourself or transfer it entirely to your children, but both of these options create further issues as discussed below. If you want to keep open your ability to finance the property, you could take out a home equity loan prior to the Life Estate Deed.
Difficulties in Transferring Property Back:
If you wish to transfer the property back to yourself for any reason, you may need the agreement of all of your children. The a Power of Appointment allows you to change ownership of the Remainder Interest among your children or other persons whom you have specified. However, not having the approval of all of the children you name originally as to the remainder interest could create a situation where a title company might not be willing to insure a purchase or refinance. Therefore, transferring back cannot be relied upon as a certainty.
Proceeds Will Go Mostly to the Remainder Holders if You Sell:
If you sell the property during your lifetime, your children will be entitled to most of the sale proceeds. Valuation of a Life Estate is made using tables published by the IRS, and is based upon your age and a specific interest rate as of the date of the sale. At current interest rates, you can estimate this percentage as being roughly your age in reverse, meaning your age is approximately the percentage ownership of your children, who hold the Remainder Interest. The Power of Appointment allowing you to change which of your children has the Remainder Interest can provide you with some protection if you need to sell the property. However, using this Power of Appointment could create title issues as noted above.
This type of Deed should only be used when none of the above risks are of particular concern, or if you have a way to minimize them. You should not use this Deed if you intend to sell the property during your lifetime, unless you either have little capital gain on the property or are willing to pay the capital gains tax on the remainder portion. You should also be comfortable with your children receiving most of the proceeds upon sale. And you should have the financial ability to pay for private aids to allow you to remain in the house without the need to use your equity in the house for a loan.
Please keep in mind that your specific situation may result in different recommendations. Please contact our office if you would like more information about the Life Estate Power of Appointment Deed or any other legal issue.