Pros and Cons of Life Estates

A life estate is established when a parent transfers title to his or her home or farm to his or her children, but reserves the right to live in the house for the remainder of the parent’s life. In legal terms, the parent is known as the “life tenant”. The children are the “remainderpersons”, i.e. the persons entitled to inherit the entire property upon the death of the life tenant.  The life tenant pays the property taxes, insurance and upkeep, and is entitled to any income generated by the property.

There are pros and cons to life estates.

Life estates are used when a parent prefers not to use a trust to own the property and doesn’t want to title the property in joint ownership with his or her children. A life estate works best when the parent knows that he or she doesn’t want to sell the property during his or her lifetime.

The assets of life estates created after August 1, 2003 in Minnesota are subject to liens by the State of Minnesota if the life tenant receives any Medicaid or state medical assistance payments. Before that date, the assets of the life estate were protected in that the life estate disappeared upon the life tenant’s death – leaving nothing to which to attach a lien. Minnesota lawmakers changed the law to allow a so-called “zombie lien” to be placed on the value of the life estate of any life tenant who uses public medical assistance.

An advantage of a life estate is that – even with a zombie lien – the lien applies only to the value of the life estate and not to the value of the entire property. That’s because the parent, as the life tenant, has only a partial interest in the property while the children, as remainderpersons, hold the rest.

Another advantage is that a life estate usually avoids the need for a probate proceeding regarding the real estate upon the death of the life tenant.

The tax treatment of a life estate is also favorable. The relevant date for tax valuation purposes for the property is the date of death of the life tenant. Ignored are the values of the property on the date that the life estate was established and on the date that the parent acquired the property. For property that is appreciating in value over time, the ability to use the death date as the valuation results in a “step-up in basis” that can lower the capital gains tax bills of the children – the remainderpersons — for any subsequent sale of the property.

There are many disadvantages to life estates as well.  For example, the establishment of a life estate does nothing to reduce the parent’s level of assets for estate tax purposes. When the donor parent retains a life estate in the property for himself or herself, the full value of a life estate property is counted for purposes of calculating estate taxes on the parent’s estate.

Furthermore, circumstances change and people tend to change their minds. If the parent later desires to sell the property, the parent, as life tenant, must share the proceeds with his or her children – the remainderpersons. And the process of selling the property or changing the financing on it is more complicated when a life estate is involved.  No longer can the parent just sign the paperwork. Now, signatures of the life tenant, the remainderpersons and the spouses of the remainderpersons are all needed on the deed or mortgage. What happens if they don’t all agree to sign?

There are tax implications as well if the parent later wants to sell the property. The parent, if the property qualifies as his or her homestead property, would be able to use the capital gains tax exclusion available to homeowners. However, the children — the remainderpersons — would have capital gains tax liability on the appreciated property for their portion of the sale proceeds. The only way that the children could also qualify for the capital gains tax exclusion is if the property was also their current homestead.

If the parent later wants to unwind the life estate without selling the property, there are issues even if the children (remainderpersons) consent to returning their remainder interest to the parent. Namely, the unwind transaction will be regarded as a gift by the children (remainderpersons) to the parent and will use up some of the lifetime tax exemption for gifts that the children are entitled to receive under the tax code.

If the parent later needs public medical assistance, there are other considerations. The establishment of a life estate disqualifies the parent for medical assistance for a period to time because persons are not allowed to give away their assets and then expect to qualify for and receive public medical assistance. The Minnesota Department of Health, and federal law, determines the length of the ineligibility period.

Another disadvantage occurs if any of the children, as remainderpersons, have creditor problems.  The life tenant’s interest would not be harmed, but the debtor child’s interest in the property could end up in the hands of the creditors. Certainly, any judgments or liens would need to be taken care of before the property is sold or refinanced.

Additionally, unexpected circumstances may result in non-blood relatives – i.e. “in-laws” –owning an interest in the property. This can be an emotional issue when the property involves a family farm or family cabin.  The ex-spouse could receive the remainderperson’s interest in a divorce situation, for example. A transfer outside the “blood” family can also occur when a child, as a remainderperson, dies before the life tenant. That’s because a child’s spouse typically would inherit the remainder interest owned by his or her deceased spouse.

In sum, the pros and cons of life estates should be considered carefully in light of the goals and circumstances of the persons involved before a decision is made to establish a life estate.

©2012 Wittenburg Law Office, PLLC. All rights reserved.