Medicaid Planning with Life Estates

By Morris Sabbagh and Robert Barnett

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MARCH 2005 - A common technique in planning for Medicaid eligibility is the transfer of an individual’s home to family members while retaining a life estate. In New York State, this technique has the potential to provide Medicaid planning benefits without the loss of tax benefits. The transfer subject to a retained life estate provides a reduced transfer penalty for Medicaid institutional benefits and avoidance of a Medicaid lien at death, without the loss of various tax benefits, including senior citizen’s real property tax exemptions and the IRC section 1014 basis step-up for property acquired from a decedent.

The unprecedented rise in residential real estate values in certain regions has led more taxpayers to put their homes on the market. The question arises: Does the relatively new IRC section 121, as implemented by the Taxpayer Relief Act of 1997, provide a capital gains tax exemption upon the sale of a life estate?

Background

Prior to the 1997 Tax Act, capital gains on the sale of a principal residence could be deferred by rolling the gain forward indefinitely into increasingly more valuable homes. Eventually, taxpayers could elect to take a one-time pre–1997 Act exclusion under IRC section 121 of up to $125,000 in capital gains.

Under the current rules, taxpayers may no longer roll capital gains forward. The new IRC section 121 allows taxpayers to exclude up to $250,000 ($500,000 for qualifying married taxpayers filing jointly) in capital gains from the sale of a principal residence that the taxpayer used for an aggregate of two or more of the five years preceding the sale. For taxpayers that fail to meet the use requirements or have sold a principal residence within the prior two years, a reduced exclusion may be available if the residence is sold because of a change in place of employment, health, or other unforeseen circumstances specified by regulations.

The Code and the Regulations

IRC section 121(d)(8) refers to sales of partial interests in a personal residence as follows:

(8) Sales of remainder interests.

For purposes of this section—

(A) In general. At the election of the taxpayer, this section shall not fail to apply to the sale or exchange of an interest in a principal residence by reason of such interest being a remainder interest in such residence, but this section shall not apply to any other interest in such residence which is sold or exchanged separately.
(B) Exception for sales to related parties. Subparagraph (A) shall not apply to any sale to, or exchange with, any person who bears a relationship to the taxpayer which is described in section 267(b) or 707(b).

By specifically permitting the exclusion for the sale of a remainder interest to a nonrelated party, this subsection appears to deal only with remainder interests. The end of paragraph A, however, suggests that the sale of a life estate is not entitled to the IRC section 121 exclusion if sold or exchanged separately.

Treasury Regulations section 1.121-4(e)(1)(i) reads as follows:

(i) In general. Except as provided in paragraph (e)(2) of this section (relating to sales or exchanges of remainder interests), a taxpayer may apply the section 121 exclusion to gain from the sale or exchange of an interest in the taxpayer’s principal residence that is less than the taxpayer’s entire interest if the interest sold or exchanged includes an interest in the dwelling unit. For rules relating to the sale or exchange of vacant land, see section 1.121-1(b)(3).

While the regulations do not state specifically that the sale of a life estate will qualify for the exclusion, they do not appear to exclude a life estate from being a qualifying partial interest. With regard to remainder interests, Treasury Regulations section 1.121-4(e)(2)(ii) states:

if a taxpayer elects to exclude gain from the sale or exchange of a remainder interest in the taxpayer’s principal residence, the section 121 exclusion will not apply to a sale or exchange of any other interest in the residence that is sold or exchanged separately.

Clarifying the Inconsistency Between the Code and the Regulations

The IRC and the Treasury Regulations appear to be inconsistent, unless the phrase “but this section shall not apply to any other interest in such residence which is sold or exchanged separately” in IRC section 121(d)(8) is read to apply only to the situation contemplated in Treasury Regulations section 1.121-4(e)(2)(ii), that is, where the taxpayer applies the exclusion upon the sale of a remainder interest in the principal residence and later sells another interest in the residence, such as a life estate.

An IRS attorney assigned to IRC section 121 advised the authors during an informal discussion that the exclusion will be permitted with respect to the sale of a life estate in a principal residence. The attorney suggested that IRC section 121(d)(8), specifically permitting the exclusion for the sale of a remainder interest, was most likely included by Congress to reverse rulings under the pre–1997 Act that denied the roll forward of capital gains and the IRC section 121 capital gains tax exclusion for the sale of a remainder interest in a principal residence. She confirmed that the restrictive language in IRC section 121(d)(8) with respect to “any other interest in such residence which is sold or exchanged separately” was intended to prevent a taxpayer who excludes the proceeds from the sale of a remainder interest in a principal residence from subsequently selling a term interest or life estate and excluding the proceeds from the subsequent sale as well.

A review of IRS rulings under pre–1997 Act IRC section 121 and IRC section 1034 is instructional. Originally, the IRS determined that the pre–1997 Act IRC section 121 applied only to the sale of the entire fee interest in a principal residence. Private Letter Ruling 8246123 involved a proposed sale by a life tenant and two remaindermen (both of whom received their interests by gift from the life tenant) of a home that all three occupied as a principal residence. The life tenant and the two remaindermen, who were all over 55 years old, each wanted to exclude their capital gains. The IRS determined that the life tenant was not entitled to the exclusion, reasoning that the transfer of a partial interest in a personal residence was not a sale for purposes of the pre–1997 Act IRC section 121. With respect to the remaindermen, the IRS ruled that the exclusion required that the taxpayer have a present right of possession in the property.

In Revenue Ruling 84-43, the IRS reversed its position on the sale of a life estate, permitting the taxpayer to take the pre–1997 Act IRC section 121 exclusion, where the life estate was the taxpayer’s only interest in the property. The IRS has continued to rely upon the reasoning in Revenue Ruling 84-43 about the exclusion upon the sale of a life interest, for both the new and old IRC section 121.

While Revenue Ruling 84-43 reverses the position taken by the IRS regarding life estates, it would appear that the IRS’ reasoning in the private letter rulings about remainder interests continues to control for the pre–1997 Act IRC section 121 exclusion. With respect to the old IRC section 121 exclusion, it appears that the exclusion is not available to exclude the proceeds from the sale of a remainder interest. The new revised exclusion addresses remainder interests directly in IRC section 121(d)(8) by specifying that the exclusion will be available upon the sale of a remainder interest.

While not stated specifically in IRC section 121, it appears that Revenue Ruling 84-43 permits excluding gains from the sale of a life estate in a taxpayer’s principal residence under IRC section 121 if it is the taxpayer’s entire interest in the principal residence. Even if such interest is not the taxpayer’s entire interest in the principal residence, it may be excluded under IRC section 121 based upon the regulations. In either event, the exclusion will be available under the new section 121 only if it was not previously taken upon the sale of a remainder interest in the same principal residence.

While the capital gains tax exclusion is preserved for the life tenant’s interest in a personal residence, unless the recipient of the remainder interest also resides in the home, the exclusion will not be available to the recipient upon the later sale of the recipient’s remainder interest. Transferring the home to a qualifying grantor trust may be an attractive alternative for some individuals in order to preserve the exclusion for both the life interest and the remainder interest.

There are many factors to consider when determining whether the use of a life estate or a grantor trust is appropriate in a given situation, and taxpayers should weigh their options carefully.


Morris Sabbagh, Esq., is a partner at Capell & Vishnick, LLP, Lake Success, N.Y., and practices estate and elder-law planning. Robert Barnett, CPA, Esq., is a partner at Capell, Barnett & Matalon, LLP, Jericho, N.Y., and practices tax law and estate planning.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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