Tax Ramifications of Planning For The Elderly
On February 8, 2006, President Bush signed into law the Deficit Reduction Act of 2005 (DRA) , which cut nearly $40 billion over five years from Medicaid, Medicare and other programs. Of greatest interest to the elderly and their families, the new law places severe restrictions on the ability of the elderly to transfer assets before qualifying for Medicaid coverage of nursing home care.
The DRA made significant changes to Medicaid’s long-term care rules, including the look-back period, the transfer penalty start date, treatment of annuities, community spouse income rules, home equity limits, the treatment of investments in continuing care retirement communities, promissory notes and life estates and state long-term care partnership programs.
For purposes of our discussion, we will limit our review to certain planning vehicles which can and should still be used when planning for the elderly and the tax ramifications associated with the use of these techniques.
BASIC CHANGES AS A RESULT OF DRA
THE LOOK-BACK PERIOD
A person applying for Medicaid coverage of long-term care must disclose all financial transactions he or she was involved in during a set period of time, frequently called the “look-back period”. The state Medicaid agency then determines whether the Medicaid Applicant transferred any assets for less than fair market value during this period. Congress does not want a person to be able to give away all of their assets one day and then qualify for public benefits the next.
The DRA extends Medicaid’s “look-back period” for all asset transfers from three to five years. Previously the agency reviewed transfers made within 36 months of the Medicaid application (60 months if the transfer was to or from an annuity and/or certain kinds of trusts). Now the look-back period is 60 months for all transfers. The extension of the look-back period makes the application process more difficult and could result in more applicants being denied for lack of documentation, given that they need to produce five years of records instead of three.
New York is phasing-in the 60-month look-back period. The look-back period will not be greater than 60 months until February, 2009, the first point at which an individual could possibly have made a transfer that occurred more than 36 months after the DRA enactment.
THE PENALTY PERIOD START DATE
The penalty period is the period during which a Medicaid applicant is ineligible for Medicaid payment for long term care services because the applicant transferred assets for less than fair market value during the look-back period.
Prior to DRA , the penalty period began on the first day of the month following the transfer. Depending on the size of the transfer and when it was made, it was possible for the penalty period to expire before an individual actually needed nursing home care. Under DRA the penalty period begins when the individual transferring the assets enters a nursing home and would otherwise be eligible for Medicaid coverage, but for the transfer.
PLANNING TECHNIQUES
I. IRREVOCABLE LIVING TRUSTS -
Irrevocable living trusts (asset protection trusts) can be powerful planning tools for seniors. These instruments are sometimes also called “irrevocable income only trusts“ or Medicaid Trusts. The critical issue is that the trust must meet the requirements of OBRA 1993 in order to exclude assets for purposes of Medicaid eligibility. This basic requirement is that the irrevocable living trust be established during the lifetime of the Grantor and he or she can have no power to revoke or amend. The trust can make distributions of principal subject to the sole discretion of the trustee, except not to the Grantor or to the Grantor’s spouse.
The document should also preclude the right of invasion by a court to force the exercise of discretion. For example, “under no circumstances shall trust principal be subject to any court direct invasion pursuant to the provisions of 7-1.6 of the Estates, Powers and Trust Laws or any other laws of New York or any other state.
Depending on how the trust is drafted, the income, estate and gift taxes will be affected in different ways. Most irrevocable living trusts are “Grantor Trusts” for income tax purposes. The trust is funded with assets that are treated as incomplete gifts for gift tax purposes and the trust assets are included in the estate of the Grantor at death.
By extending the look-back period for all transfers to 60 months, the DRA has removed a previous negative impact that used to apply to transfers to trusts versus transfers of outright interests, which had a shorter look-back period. Now that all transfers must be looked at in light of the five-year restriction, the potential benefits of a trust can significantly outweigh the additional effort and expense to establish them.
Most clients desire to transfer the assets remaining at their death to their children, but do not want to give them away “now” or during their life while they may still need them. The use of a trust can remove some understandable anxiety about their children “holding” assets for the parent. For many reasons, outright transfers may not be appropriate in a given family situation. Children with creditors or potential creditors could subject the parent’s assets to claims. Children with substantial assts may not want additional assets for either tax or education planning purposes, especially if the are not supposed to use the assets until the parent’s demise.
INCOME TAXES CONSEQUENCES OF IRREVOCABLE LIVING TRUSTS
Under the Grantor Trust Rules (IRC 671-677), all of the income from the trust can be taxable to the Grantor (senior) regardless as to whether the trust is drafted for the senior to receive the income on a mandatory basis, a discretionary basis, or not at all. If the income is not mandated to the Grantor, the trust can provide for a power to remove and replace the trustee (other than the Grantor or the Grantor’s spouse) in order to establish Grantor trust status. By having the trust treated as a Grantor trust, the Grantor can have all of the trust income taxable to him or her, at a lower tax bracket. This allows the Grantor to further deplete his/her own assets.
A trust document needs to be reviewed to determine whether the Grantor Trust rules will apply. This is significant since it will determine how the tax returns should be filed. This is an area of confusion oftentimes for the trustee of the trust who may not understand the tax consequences of the trust that was set up. Several key code sections are often incorporated into the trust to ensure grantor trust status. Below are some of these codes sections:
Code Section 673 (Reversionary Interests) – not often seen in this type of planning, however the Grantor will be taxed if he/she retains a reversionary interest in the trust principal or income with a present value of more than 5% of the value of the trust.
Code Section 674 (Power to Control Beneficial Enjoyment) – The Grantor is treated as the owner if he/she retains the right to control the beneficial enjoyment of the trust property or its income. There are several exceptions to this rule under 674(b) which will not cause the trust to be deemed a grantor trust. One area that can cause Grantor trust status is if the Grantor holds an unrestricted power to remove, substitute or add trustees and to designate himself or herself as the replacement trustee.
Code Section 675 (Administrative Powers) – The income will be taxed to the Grantor if he/she retains possession of certain administrative powers such as the power to deal for less than adequate and full consideration, the borrowing of trust funds, borrowing without adequate interest or security and general powers of appointment.
General Powers of Administration include the power to vote or direct the voting of stock, the power to control the investment of trust funds or the power in a non-fiduciary capacity to reacquire trust corpus by substituting other property of equal value.
GIFT TAX CONSEQUENCES OF FUNDING AN IRREVOCABLE TRUST
Upon funding the trust, there may be a transfer of assets for gift tax purposes, depending on the terms of the trust. The transfer of assets into an irrevocable trust will always trigger a transfer subject to the Medicaid penalty rules. The transfer of assets to an irrevocable trust will be considered incomplete for gift tax purposes if the Grantor reserves the right to re-vest the beneficial title of the property to himself or to the extent a reserved power allows for the naming of new beneficiaries or to change the interests of the beneficiaries. All of these powers would make the assets available for Medicaid planning purpose and would cause the gift to be considered an incomplete gift for gift tax purposes.
From a Medicaid eligibility context, the Grantor could retain a power over the disposition of the trust assets, such as a testamentary power of appointment over the remainder upon death, limited to a class of beneficiaries, excluding the Grantor, Grantor’s estate and creditors of the Grantor’s estate. If Medicaid planning is being implemented for the spouse as well, then the spouse, the spouse’s estate and creditors of the spouse and spouse’s estate should also be excluded. This provision can be used to render the funding of the trust as an incomplete gift for gift and estate tax purposes while removing the assets from the Grantor’s control under Medicaid rules.
If the transfers funding the trust were classified as incomplete gifts for gift tax purposes, then distributions from the trust to persons other than the Grantor will be taxable gifts. This is typically the case with this type of asset protection trust. For Medicaid purposes, the distributions would not be subject to the Medicaid penalty rules since the Grantor gave up all ownership and control at funding under the terms of OBRA 1993.
The key to using this type of trust is the client’s ability to resist the need for Medicaid payment of service until the five-year look-back period has passed. Either the client remains healthy or utilizes assisted living services or has reserved enough other assets outside of the trust to cover his or her needs during that time. If the client dies before the look-back period has expired, the family still receives a step-up in cost basis for the assets held in the trust and avoids the probate process for all assets held in the trust. If the client needs to access the Medicaid system prior to the passage of 60 months, then “crisis planning” can still be implemented.
In order to determine whether the gift is complete for gift tax purposes, the trust must be reviewed in order to determine whether the Grantor has given up dominion and control over the assets. The trust can be deemed defective for income tax purposes but not for gift tax purposes meaning that the Grantor will pay the income taxes, but the transfer of assets to the trust will be respected for gift tax purposes thereby resulting in a taxable gift. Review of Treasury Regs. 25.2511-2 can be a good starting point to determine whether the transfer of assets to the trust is complete for gift tax purposes. As discussed above, the transfer of assets to the trust may want to be deemed incomplete for gift tax purposes, if the Grantor is not in a taxable estate scenario since the assets would receive a step up in basis upon the death of the Grantor.
II. PROTECTING THE FAMILY HOME-
Clients say that they want to “give their house to their children”. If they happen to work with an uniformed advisor, they may actually sign a deed that transfers their primary residence outright to their children. Most likely, the result will not be what they had intended to accomplish. We must first establish the client’s objectives regarding their property in order to determine the appropriate asset preservation technique.
Real property, and especially the primary residence of an individual, has unique characteristics and treatment under the law, which provide creative transfer alternatives versus other types of assets.
If the client is attempting to protect this asset from having to be sold to pay for the potential cost of long-term care, there are many considerations that should be discussed.
MEDICAID LIEN:
The New York State Department of Health has the right to impose a lien on real property for Medicaid correctly paid on behalf of a Medicaid Applicant/Recipient (M/A)’s behalf if the individual is permanently institutionalized and is not reasonably expected to return home [SSL 369(2)(a)(ii)].
The standard used to determine the reasonable expectation is based upon the A/R’s subjective intent. Filing an affidavit expressing the client’s intent to return home with his or her Medicaid application will evidence the subjective intent necessary to prevent the imposition of an immediate lien. The A/R would then have the time to transfer the property to an “exempt” individual or to engage in other planning techniques.
TRANSFER OF A LIFE ESTATE
A life estate is an interest in real property held during lifetime by a party by which the party has the exclusive right to possession, control and enjoyment of the property. A life estate is a freehold estate, which is subject to protections under the law. (Note: the conveyance must be a “life estate”, not “life use” or other terminology sometimes seen on deeds].
A life estate may be created by devise or conveyance. A transfer or devise of a life estate gives to the holder of a life estate a possessory interest in the property and not merely the right of occupancy. As the life tenant is the exclusive owner of the land during life with the sole right to its use and enjoyment, the future interest holder has no present right of enjoyment and no tangible or physical ownership of the land. The future interest holder’s interest in the land will ripen into ownership of the land itself upon the death of the life tenant.
Medicaid is not permitted to file a lien against the life estate of an A/R. Also, a life estate is not a countable resource for Medicaid eligibility. A life estate can enjoy the same principles when applied to the primary residence or to other real property.
EXEMPT TRANSFERS
Transfers from a prospective M/A to the following individuals (or a trust for their sole benefit):
1) the spouse of the applicant
2) a child of the applicant who is under age 21
3) a child of the applicant who is certified blind or disabled regardless of age
4) a sibling of the applicant who has an equity interest in the home and who has been residing in the home and using it as a primary residence for a period of atleast one (1) year immediately before the date the A/R becomes institutionalized
5) a caretaker child who is a son or daughter of the applicant who was residing in the home as the child’s primary residence for a period of at least two (2) years immediately before the date the A/R becomes institutionalized, and the caretaker child must have provided care to the applicant which permitted him or her to reside at home rather than an institution.
DEED WITH A RETAINED LIFE ESTATE?
Prior implementation of the DRA, the transfer of a client’s home to their children, while retaining a life estate, was an attractive option for individuals of more modest means. It preserves what typically is their largest asset, while not requiring them to part with any liquid assets. It accomplishes this at a modest cost. This all continues to be advantageous but, since implementation of DRA, timing has become an issue.
The transfer of a home (or a remainder interest in a home) by someone who might eventually need nursing home care is considered an outright gift, subject to the five –year look-back. For purposes of Medicaid, the value of the gift of a home with a retained life estate would be the fair market value of the home on the date of the gift, less the actuarial value of the retained life estate. The actuarial tables used to determine the values vary from county to county within New York State. How long or short the period of ineligibility is as become much less important because the ineligibility period does not commence under DRA until the applicant is impoverished according to Medicaid standards and otherwise eligible for Medicaid.
Vacation homes continue to be a good opportunity for use of deeds with retained life estates. Deeding early is less of a risk with vacation homes, if the children want to continue to own them. If a parent enters into a nursing home and cannot continue to use the property or pay its expenses, the children will be more likely be able to raise the funds because of their current enjoyment of the property as compared to a principal residence.
TRANSFER TO TRUST?
The extension of the look-back period on all gifts to five (5) years has eliminated a major disadvantage to the use of a trust to hold residential real property.
Some people may feel more comfortable transferring the remainder interest of their home to a trust instead of to their individual children, thereby allowing for more coordinated action by a trustee (one child) after their death instead of having multiple owners of the property (especially incases with multiple children or if family conflict exists).
A very important advantage of the trust to hold residential real estate comes when the parent has to leave the home either to enter a nursing home or some other arrangement when using a deed. If the home is retained, it may be necessary for the children to pay the cost of its maintenance and taxes. This burden may result in the need to sell the home, with the value of the life estate being lost to nursing home expenses. The trust has no similar problem.
The School Tax Relief Program (“STAR”) provides partial exemption from school property taxes. The enhanced STAR exemption is exclusively for those 65 years old and older and with income below the statewide standard. An application must be filed with the assessor for the STAR exemption. When property otherwise eligible for the STAR exemption is transferred into trust, the beneficiary of the trust would be treated as the owner for purposes of the exemption. If the senior citizen remains in the home as a beneficiary of the trust, then for STAR purposes, the owners of the home are the parents and not the trustees or other beneficiaries. Care must be taken not to alter the nature of the retained life estate, such as making it simply a right to occupy the property.
By correctly using the Grantor Trust Rules, it is possible to shift assets in trust to the younger generation, thereby protecting them from Medicaid, but having the older generation still pay the tax, in their presumably lower bracket. The capital gain exclusion for primary personal residences ($250,000 for single, $500,000 for married), provided under IRC Section 121, can also be preserved and taxed to the grantor by using a power that accomplishes that under IRC 671-677, if the property is sold during the lifetime of the life tenant.
PURCHASING LIFE USE FROM ANOTHER:
Although not previously prohibited, the DRA specifically authorizes a person to purchase a life estate in the home of another (for full consideration) without it being considered an uncompensated transfer. In order to qualify, the purchaser of the life estate must reside in the home for a period of at least one (1) year from the date of purchase.
If a purchase of a life estate is made, it may be combined with an exempt transfer in certain circumstances so as to affect the complete transfer of the home back to the child/seller of the life estate. For example, if a parent purchases life use from a child and resides with the child for one year, then the purchase of the life use is exempt. If the parent resides with the child for another year, and if the child is a care-giver, then a subsequent transfer might be made extinguishing the life estate completely, under the care giver child exemption.
INCOME TAX CONSEQUENCES OF PROTECTING THE FAMILY HOME
When an individual sells his/her their home, the individual is entitled to a capital gains exclusion of $250,000 for a single taxpayer, $500,000 for married taxpayers if it was the taxpayer’s primary residence for 2 out of the past 5 years. There is special treatment afforded under code section 121, for individuals residing in a nursing home. If during the preceding 5 years the taxpayer resided in that principal residence for at least 1 year in total, and the taxpayer has resided in the nursing home, he will be eligible for the gain exclusion. There are also hardship provisions that may apply if this test is not met.
Thus as oftentimes happens as families try to “preserve the home”, there will be a transfer/gift of the family home to the next generation. This results in the loss of the capital gains exclusion unless the family member who receives the gift will qualify for this exclusion under code section 121. When advising clients, the client oftentimes feel that it is better to lose the gain exclusion than to lose the home to pay for nursing home care.
The transfer of the home to family members while the owner retains a life estate can also result in tax issues. If the home is sold while the individual retains the life estate, not only are the proceeds divided between the life tenant and the remaindermen, but the remaindermen will also pay incomes taxes on any gain realized on their proportionate share if the home is not their principal residence. The taxpayer with the retained life estate would be still be eligible for the exclusion under IRC Section 121.
GIFT TAX ISSUES OF TRANSFERRING THE HOME
If the owner of the home transfers the title to a family member, that is a completed gift and a gift tax return should be filed. The owner has relinquished dominion and control over the asset.
Generally if a taxpayer retains a life estate, he would be deemed to have made a gift of the remainder interest and a gift tax return would be required. If the taxpayer retains a life estate and the remaindermen are family members, IRC section 2702 will apply. Although the code section refers to transfers in trust, a gift of a remainder interest to a family member applies. This causes the value of the retained interest to be valued at zero. Thus, the full value of the property is subject to gift tax. Also, under IRC Section 2036, Transfer with Retained Life Estate, the value of the home will be included again, although the estate tax return does make adjustments for prior taxable gifts so the same asset will not be taxed twice. If the deed places a Special Power of Appointment in it, the gift will be considered incomplete for gift tax purposes.
MEDICAID CRISIS PLANNING
When clients need to pay for the cost of long term care in the immediate future, the first thing necessary is to obtain an exact total of the assets and income of the person needing care and that of his or her spouse. Many times, the spouse or children have not planned for this event and do not know what all of the assets are or where they are located. If the client has previously worked with the firm or works with a financial planning consultant, the task may be much easier.
For 2008, basic Medicaid eligibility allows an individual to retain $13,050. in assets (as of 4/1/08), a prepaid irrevocable burial account and $1,500 face or cash value of life insurance and $50.00 per month in income plus the cost of private health insurance premiums and/or a prescription drug insurance plan.
If the applicant has a spouse, he or she may retain assets of an amount between $74,820 and $104,400 (based on one-half of their joint assets at the time the Medicaid applicant entered the nursing home). He or she may also retain a home with up to $750,000 in equity and an automobile of any value. He or she may also establish a prepaid burial account. The spouse may also keep $2,610 of monthly income.
Any transfer of assets to reach these eligibility levels within the look-back period will trigger a penalty that will not begin to run until an application for Medicaid is made and the applicant would otherwise be eligible. Therefore, the key is to get the penalty started and to at the same time have a “reserve” of assets with which to pay the nursing home during the penalty period.
This can be accomplished by making a gift and at the same time loaning assets in the form of a promissory note. This will create an income stream to supplement the applicant’s income and privately pay for the cost of care during the penalty period resulting from the gift. The repayment terms of the promissory note must be actuarially sound and made in equal monthly amounts and Medicaid must be named the remainder beneficiary of the note for any money they are owed. This will never be a problem because Medicaid will not start to pay for care until the penalty period has run and the term of the note is complete.
TAX RAMIFICATIONS OF LIQUIDATING ASSETS QUICKLY
When an individual needs to raise cash to pay for care, assets are cashed in and the tax consequences are not considered until tax time which can be unfortunate. Many elderly have savings bonds that have significant accrued interest that they will pay taxes on when they are cashed in. These same individuals may not have had income tax return filing requirements prior to this since their income is under the filing threshold. Planning should be done with the individuals to possibly cash in these savings bonds over of period of years even if it results in them paying minimal tax. Even if these individuals never end up in a nursing home, some time in the future, the tax bill will come due and oftentimes either their estate or their beneficiaries end up paying a much higher rate of tax than they would had some planning been done. The worst case that happens is when the applicant needs to pay for their care for a period of time and starts liquidating assets that have significant income attributable to them. Then the applicant not only has high medical expenses, but due to higher adjusted gross income levels, more of those expense are not deductible due to the medical expense floor which allows medical expenses to be deductible to the extent that they exceed 7.5% of income.
This can also be said for IRAs which are not subject to asset rules but RMD are considered income for these rules. Annuities often provide a big tax hit for the annuitant when they are cash in and for the beneficiaries of the annuity.
To help minimize exposure to the payment of nursing home expenses, long-term care insurance can help. The premiums are deductible for Federal purposes to a certain extent, and they are eligible in New York State for a credit against taxes. Although many individuals deem this coverage as expensive, when the coverage is needed, it can give the family time to plan accordingly.
