A life estate is a legal arrangement granted to a life tenant for the use and enjoyment of the property during his lifetime. After the life tenant’s death, the property is transferred to the remainderman, who acquires full ownership over the property.
The life estate deed is usually used to transfer property from the parent to the child in order to avoid probate. The parent, who is the grantor, transfers the property to his child, subject to the parent’s life estate. This arrangement, however, is prone to complications.
The problems in a life estate arrangement can be categorized from the grantor’s point of view, the life tenant’s point of view, and the remainderman’s point of view. The way to avoid those problems is to not set up a life estate in the first place, opting for a trust instead.
One of the major problems about transferring property under a life estate from a grantor’s point of view is its irrevocability. Once the grantor transfers property under a life estate deed to the remainderman, subject to the grantor’s life estate, this transfer is irrevocable.
When the grantor/life tenant and the remainderman subsequently have a dispute, the grantor/life tenant cannot revoke the transfer to the remainderman anymore. The remainderman has a vested interest over the property, and the property cannot be sold, mortgaged, or substantially altered without the remainderman’s consent.
When the grantor/life tenant needs the property for his future needs, long-term care, or any other unforeseen circumstance, the grantor/life tenant cannot take back the property without the consent of the remainderman.
When the grantor/life tenant transfers the property within the Medicaid lookback period (usually 60 months), the value of the life estate will be considered in computing for the penalty under the lookback period. On the other hand, if the property is not transferred, the property (if considered the applicant’s main residence) is a non-countable asset for purposes of determining Medicaid eligibility. (Caveat: Even if the grantor’s property is a non-countable asset, it is still subject to Medicaid estate recovery.)
Life estates can also be subject of conflict, disputes, and contests among children or relatives, especially when the property is transferred only to one child, to the exclusion of the others.
From the life tenant’s point of view, the life tenant’s rights are limited to the use and enjoyment of the property during his lifetime. Unless expressly excluded, this right may include the right to rent out the property. The life tenant, however, cannot sell, mortgage, or substantially alter the property without the consent of the remainderman. The life tenant has to pay for all taxes, fees, maintenance, and administration expenses related to the use and enjoyment of the property.
If the life tenant or remainderman wishes to sell the property, the life estate and the remainderman’s interest will be valued based on a pre-determined formula. The sales proceeds are then distributed based on the formula.
From the remainderman’s point of view, the remainderman cannot enjoy the property until after the lifetime of the life tenant. This delay in the turnover of complete ownership over the property can be agitating, especially when the remainderman is in need of money. The life estate also diminishes the value of the remainderman’s interest. The distribution of a sale of a property under a life estate usually depends on the age of the life tenant. The higher the life tenant’s expectancy, the lower the value of the remainderman’s interest.
From the remainderman’s tax point of view, when the remainderman finally receives the property and sells it, the tax basis is computed based on the value of the property when the life estate was created. For example, if the grantor bought the property for $100,000, the value of the property at the time the life estate was created was $300,000, and the remainderman is able to sell the property after the life tenant’s death at $500,000, the remainderman’s tax basis is $300,000 and not $100,000. The remainderman will have to pay capital gains tax based on the $200,000 gain, computed at $500,000 less $300,000.
On the other hand, if the child inherits the property upon the parent’s death without a life estate deed, the child will receive a stepped-up tax basis. For example, even if the parent acquired the property for $100,000, when the market value of the property is $500,000 at the time of the parent’s death, the child receives a stepped up basis of $500,000. When the child subsequently and immediately sells the property for $500,000, the child is not liable for any capital gains tax on the sale.
An alternative to the life estate deed is the revocable trust. In a revocable trust, the property avoids probate, similar to a life estate deed. This means that the property can be transferred immediately to the successor trustee without need of probate proceedings.
However, unlike a life estate deed, if the grantor and the beneficiary get into a dispute and the grantor desires to change the name of the beneficiary, it is possible because a revocable trust can be modified, amended, or revoked without need of obtaining the consent of the beneficiary. The beneficiary in a revocable trust does not have any vested right, unless and until the grantor dies.
Unlike a life estate deed without any stepped up basis, the revocable trust enjoys a stepped up basis when the grantor dies. In the same example above, if the grantor acquires the property for $100,000 and dies when the property value is $500,000, the trust gets a stepped-up basis of $500,000 which is used for purposes of computing capital gains tax.
The revocable trust can have several beneficiaries, where distributions can be divided equally or in percentages, depending on the grantor’s preference. This minimizes risk of disputes and conflict among children.
When the grantor becomes disabled or incapacitated in a revocable trust, the successor trustee can immediately step in to manage the property on behalf of the disabled or incapacitated grantor without need of guardianship proceedings. In a life estate deed, the grantor/life tenant cannot do anything to the property or use the property for his care costs without the remainderman’s consent.
Life estate deeds are an estate planning tool which can be effective but can also create complications. The more modern way of transferring property with less conflict and disputes is the trust, either revocable or irrevocable, depending on the objective of the client. Should you need more information about life estate deeds, we at the Law Offices of Albert Goodwin are here for you. We have offices in New York City, Brooklyn, NY and Queens, NY. You can call us at 212-233-1233 or send us an email at [email protected].