Protect Your Assets: Irrevocable Trust vs. a Life Estate

By: Jacqueline M. Caswell, Esq.

One very big concern that has been growing recently is the possibility that a person’s hard-earned assets will have to be spent down to cover the costs of necessary long-term medical care, leaving nothing to transfer to the healthy spouse, children, or other loved ones. Long-term care costs have been rising, and the law allows Medicaid to look back up to five (5) years to determine if any assets have already been transferred. For that reason, it is important to come up with a strategy to protect these assets while a person is healthy, before the need for long-term medical care arises. The longer that a person waits to protect assets, the more likely it is that the assets cannot be protected.

One way for couples to avoid having their remaining assets used to pay for long-term medical care is to place the assets in an irrevocable trust as part of a comprehensive estate plan. Many people hear the words “Irrevocable Trust” and think that the irrevocable nature of the instrument implies inflexibility and rigidity, or that they will lose control over their assets. This is a common myth. An irrevocable trust may enable individuals to retain a significant degree of control over assets during their lifetime, while providing for protection from creditors and reducing tax liability for the individual’s heirs following their death. Putting assets into an irrevocable trust also may help to reduce the risk that a child’s creditor or ex-wife will take the assets while the couple is alive.

Another option considered by many couples is the option of 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(s), yet gives the owners/grantors the legal right to live on the property as long as either of them is alive. This approach can ultimately protect homeowners from having the property taken to pay for long-term care, but, not unlike the irrevocable trust, this can also create some issues.

Example

Consider a hypothetical married 70-year-old couple in good health with two (2) children. They own a home worth approximately $500,000 (purchased for $100,000) and have approximately $300,000 in other assets (including life insurance). The couple wants to protect their assets from being taken to pay creditors, including long-term care providers, and having their real property dealt with in probate.

Option #1 – Life Estate:

The couple consult an attorney and it is recommended that they execute a deeded transfer of their real property to their children, but retain “life use” of the property, and execute a Last Will & Testament to handle the distribution of $300,000 in other assets upon their deaths.

Potential Issues: If the parents transfer the property to their children, retaining a life estate, and later decide to sell, all four individuals are considered owners. This essentially means that the parents cannot sell the home without the consent of all children who hold the remainder interest. Thus, a child who wants to keep the home in the family can stop the parents from selling. The children, as well as the parents would have to sign the purchase/sale agreement and all documents pertaining to the sale of the property.

If the parents sell after transferring the property to their children, the children would be assessed a capital gains tax. Let’s assume that the capital gains tax rate on real estate is 25% and use our example from before. Since the tax is based on the difference between the purchase price of the house and the sales price, 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 net capital gain of $75,000. Each child would then have to pay approximately $18,750 in capital gains taxes on the sale of the parents’ home. 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.

In order to avoid the above situation, assuming the children are in agreement, your attorney can easily prepare the documents necessary to transfer the children’s interest in the property back to the parents. By transferring the children’s interest back prior to the sale, the children effectively alleviate any and all capital gains problems they might have otherwise faced as a result of retaining their remainder interest.

In conclusion, if the couple does not foresee any of the aforementioned issues becoming a problem, the reservation of a life estate together with a Last Will & Testament would address many of their concerns. The life estate can help solve many of their estate planning issues, and do so effectively, affordably, and with relative ease.

Option #2 – Irrevocable Trust:

The couple consult an attorney and it is recommended that they transfer some, or all, of their assets to an irrevocable trust and execute a “pour-over will”. The husband and wife would be the grantors to the trust and would choose an independent trustee to manage the trust during their respective lifespans. The trustee would have the ability to pay necessary expenses from the trust assets.

In this example, any assets which were put into the irrevocable trust are not included for purposes of calculating the person’s Medicaid assistance (assuming we are past the 5 year lookback period, the period of time after assets are transferred to the trust), included in the estate for the estate tax purposes, or considered in probate. The State can only lien assets included in the probate estate to pay for long-term medical care. The probate estate includes only those assets owned individually at the time of death.

Assets owned by an irrevocable trust are not owned in the individual’s name and thus are not part of the probate estate. Therefore, these assets are not subject to Medicaid’s estate recovery provision. That means, ultimately, that assets in the trust will be preserved for the person’s heirs. Additionally, for some, using an independent trustee can give a person a much greater sense of safety than transferring assets outright to children as gifts.

Potential Issues: If real estate is being contributed to the trust, a new deed must be prepared to transfer it into the trust. If bank accounts or securities accounts are being transferred, the old accounts must be closed and new ones in the name of the trust must be established. If valuable artwork, jewelry, or other personal property is to be contributed, deeds of trust in conformity with the requirements of state law must be executed. Indeed, ALL of the person’s property (with the exception of retirement accounts and any accounts that otherwise pass by a beneficiary designation) must be retitled into the name of the trust. All of these things take time, and often are accompanied by additional costs and expenses to effectuate the transfers.

Once the irrevocable trust is created and all of the assets have been transferred into the trust the couple may wish to make changes to the trust. If any changes are made to the trust, their once irrevocable trust becomes a revocable trust which does not provide the couples estate with the same protections. The couple would have to create a new irrevocable trust, go through the time and incur the costs associated transferring assets to the new irrevocable trust, and start a new 5 year lookback period.

Although there are not too many things you can rely on in life, one thing you can be certain of is that things will change. Federal and state laws, state regulations, and agency policies govern Medicaid eligibility. These rules change frequently, usually with no “grandfathering” for planning undertaken prior to the change. When considering whether to transfer assets to an irrevocable trust to preserve those assets from having to be spent down on long-term care costs, it is important to remember that the law in effect today is unlikely to be the law in effect after the five-year ineligibility period has expired. A person who is applying for Medicaid benefits must disclose the existence of an irrevocable trust on the application, which could change the benefits received.

An irrevocable trust that is intended to preserve assets from being spent down on long-term care costs must not allow for any distributions of principal from the trust to the person whose assets funded the trust, including distributions that might pay for home care or assisted living. Suppose, for example, an individual creates an irrevocable trust in New York for his or her benefit and names an “independent” individual or bank as trustee. Further assume the trustee has complete discretion to invade the trust income and principal for the benefit of the creator and the creator’s family. In this scenario, the trust assets would not be protected against creditor claims because EPTL Sec. 7-3.1 clearly provides that “A disposition in trust for the use of the creator is void against the existing or subsequent creditors of the creator.” This principle was first codified in 1787 and has been the firmly established law in New York State ever since.

In conclusion, the irrevocable trust is the only type of trust that allows the couple to transfer assets in a manner that will provide protection from their creditors, including the costs of long-term care, and their children’s creditors (including ex-spouses) while allowing the parents to benefit from the income generated from the assets that comprise the trust during their lives. But, back to our ongoing example, is the income off of the interest on less than $300,000 in assets (which includes life insurance) going to be enough for this couple to maintain their current way of life? The couple is already 70, will they outlive the 5 year lookback period? And, are the additional costs associated with the creation of an irrevocable trust worth it for this couple who have less than $800,000 in total assets?

Which is best?

It depends! That’s why we utilize the Life Estate and the Irrevocable Trust, among other strategies, as estate planning tools depending upon each client and their particular situation. Therefore, it is crucial to consult with an attorney who will conduct an in-depth assessment, and based upon that assessment, specifically tailor a plan to suit your needs .


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