Life/Trust Debate: Life Estate vs. Irrevocable Trust: Pro’s and Con’s
Irrevocable Trusts – Not as Frightening as You Might Think in the Life Trust Debate!: Part 2
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Many families consider using a life estate to protect their homes rather than transferring property into a trust. Creating a life estate requires executing a deed that transfers ownership of the property to the grantee, yet gives the owners the legal right to live on the property as long as either of them lives. This approach can ultimately protect homeowners from having the property taken to pay for long-term care, but can also create huge unnecessary problems.
If the children experience financial difficulty during the life of the parents, creditors may be able to put a lien on the residence. They could not force a foreclose on the lien while the parents were alive, but the existence of the lien would still cause problems for the children when the property transfers following the death of both parents. If a child gets divorced, the house in a life estate is considered a marital asset and the ex-spouse could get half.
Life/Trust Debate: Life Estate Creates Conflicts of Interest
A life estate also means that the parents cannot sell the home without the consent of all children that hold the remainder interest. A child that wants to keep the home in the family can stop the parents from selling.
Life/Trust Debate: Life Estate Creates Capital Gains Issues
If the parents sell after transferring the property to their children, the children would be assessed a capital gains tax. In 2013, the capital gains tax rate on real estate is 25%. The tax is based on the difference between the purchase price of the house and the sales price. Consider the hypothetical Massachusetts couple with two children and a house worth $500,000. Assume the property cost $100,000. If the parents transfer the property to their children, retaining a life estate, and later decide to sell, all four individuals are considered owners. The children would be assigned approximately 50% of the cost basis in the property and approximately half of the sale proceeds. That means that each child would be assumed to have earned income of $100,000 from the sale, minus $25,000 of the cost basis, which leaves a capital gain of $75,000. Each child would then have to pay approximately $18,750 in capital gains taxes on the parents’ home.
This unjust outcome becomes even more unfair when the capital gains tax exclusion is factored into the equation. The law allows a capital gains tax exclusion of up to $500,000 for a married couple on a person’s primary residence. That means, if the parents lived in the property and used it as their home for at least two years during a five-year period before the sale, they are allowed to exclude up to $500,000 of the sale’s proceeds from being taxed. Since each parent’s share of the sale proceeds is only $100,000, they pay no taxes – yet their children get a tax bill solely because the parents transferred the property to them before selling it. Also bear in mind that, had the parents not transferred the property to their children, their capital gains would have been $400,000, and no capital gains taxes would have been owed. When looking at these numbers, it is clear that transferring the property to the children and retaining a life estate may not benefit the children. It may also cause strife if the children refuse to sell because of the potential tax liability. Remember that the parents cannot sell without the children’s agreement.
Life/Trust Debate: Irrevocable Trust Benefits vs. a Life Estate
If the couple decided instead to transfer the home to an irrevocable trust, they could still retain a joint life estate. However, the remainder interest would belong to the trust. In this scenario, the parents could sell the home without their children’s consent and without facing the capital gains tax issues in the prior example. The couple would be considered the owners for income tax purposes and could take the full benefit of the capital gains exclusion following a sale. They would pay no capital gains tax. In addition, creditors of the children would have no access to the property during the parents’ lives and the trust would give the couple some protection against their own creditors.
Top 6 things to consider when choosing an Irrevocable Trust
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