Elder Care and Estate Planning: Reconciling Strategies

By Howard Davidoff

In Brief

Maximizing Asset Retention in the Family Unit

The methods for achieving elder care and estate planning goals can often conflict with each other. Any strategy designed to minimize one set of financial obstacles runs the risk of opening vulnerabilities in another area. By carefully considering the consequences of each strategy and making sound decisions, planners can ensure that a maximum of assets are retained within the family unit, a minimum of estate taxes are incurred, and elder care costs are minimized.

When it comes to planning for wealth preservation, a planner must consider three basic obstacles in the effort to keep assets within a family:

Planners must always be aware that employing one common strategy to minimize or avoid one of these obstacles may severely compromise efforts to avoid another. The following summarizes some of these potential pitfalls, and offers suggestions as to how to minimize unintended exposure.

Qualified Postmortem Disclaimers

Estate planning opportunity. Under the current tax laws, anyone with assets net of expenses and deductions of $1 million or less can die estate tax–free in 2003 [IRC section 2010(c)]. This amount, the applicable exclusion amount (AEA), is slated to increase to $1.5 million in 2004. Subsequent increases in the AEA will culminate in a one-year estate tax repeal in 2010 [IRC section 2210(a)]. However, in 2011, the AEA is scheduled to return to this year’s level of $1 million, unless Congress extends the repeal [P.L. 107-16 section 901 (2001), 6/7/01].

Because of the constantly changing AEA, one cannot determine how much will pass estate tax–free in the year of death. Accordingly, estate attorneys often advise that a married couple leave their net assets directly to each other, with a provision that whatever property the surviving spouse disclaims be directed to a testamentary trust. In order for the disclaimed property not to be deemed an inheritance, the disclaimer must be made in a manner qualified by IRC section 2518. Doing so presumes the named beneficiary (i.e., the surviving spouse) to have predeceased the decedent to the extent of the property so disclaimed, negating any inheritance by the disclaiming party. In order to qualify for this provision, the following criteria must be met:

This, in effect, gives the surviving spouse a postmortem opportunity to maximize the availability of the AEA and the unlimited marital deduction [IRC section 2056(a)] in order to minimize estate taxes.

Elder-planning problem. Because nursing home costs in many areas are approaching $10,000 per month, individuals faced with these costs are increasingly trying to receive government assistance through Medicaid. To qualify for this subsidy, the Medicaid applicant must show financial need. For example, in New York State, a 2003 applicant was limited to $662 per month of income and $3,850 of total nonexempt assets [exempt assets include a personal residence (as long as the applicant intends to return home), a prepaid funeral, an automobile, personal jewelry, and household furnishings].

Many individuals have transferred assets out of their name in an effort to “impoverish” themselves to qualify for Medicaid. However, any asset transfers (except to an individual’s spouse or for the benefit of a disabled child) trigger an ineligibility period. This period is measured in months equal to the uncompensated transfer’s value, divided by the average monthly nursing home cost in the transferor’s area as determined by the Department of Social Services [42 USC section 1396 p(c)(I)(E)(I)]. Spousal disclaimers qualify as such a transfer.

Example. Harold dies, leaving his spouse, Myrna, $240,000; she also owns a personal residence worth $1 million. To avoid having a taxable estate, Myrna disclaims Harold’s bequest, so that the $240,000 winds up in a unified credit shelter trust, as provided for in Harold’s will. However, should Myrna be in a nursing home or contemplate entering one in the near future, her disclaimer will initiate an ineligibility period. Assuming an average monthly nursing home cost of $8,000, this will disqualify her from Medicaid assistance for 30 months.

Two observations can be made. First, for purposes of determining Medicaid eligibility, there is a maximum 36-month “look-back” period for transfers made to individuals [42 USC section 1396 p(1)(B)]. Therefore, if the disclaimed amount were $320,000, there would only be a 36-month waiting period. However, if Myrna applied before the 36-month waiting period expired, she would have to wait the full 40 months before reapplying ($320,000 ÷$8,000). (For transfers made to Medicaid qualifying trusts, the look-back period is 60 months.)

Second, for applicants that apply for Medicaid assistance for in-home care as opposed to nursing home care, the ineligibility period rules do not apply.

Contingent QTIP solution. In order to maximize both estate planning and elder-planning benefits, it is advisable to leave property in a will to a qualified terminable interest plan (QTIP), as opposed to leaving it directly to a spouse. The QTIP is a trust that must provide that the spouse be entitled to income for their life. As long as the spouse is a U.S. citizen, and the executor makes a timely election to have the trust qualify by the estate tax return’s due date (including extensions), this trust qualifies for the unlimited marital deduction [IRC section 2056 (b)(7)].

A QTIP still qualifies for the marital deduction even if the will provided for a contingency plan in case the executor failed to make a timely QTIP election [Treasury Regulations section 20.2056(b)-7(d)(3)(i)]. If the executor is someone other than the spouse, the decision not to elect QTIP treatment cannot constitute a nonexempt transfer of assets that would subject the spouse to a Medicaid ineligibility period. Moreover, the executor can make a partial disclaimer from the QTIP to a unified credit shelter trust to maximize estate tax savings.

Furthermore, because the QTIP election need not be made until the estate tax return’s extended due date, the executor will have 15 months from the date of death to decide how to proceed. Disclaimer elections normally must be made within nine months of the date of death.

Primary Residence Transfer with Retained Life Estate

Estate and elder-planning opportunity. Even though an applicant’s primary residence is an exempt asset that will not prevent one from qualifying for Medicaid, once the applicant and spouse are no longer expected to return home, the situation changes; a lien can be put on the residence to reimburse the government for expenses paid on the applicant’s behalf. A popular technique employed to preserve the family home from this lien is to transfer the house from the applicant’s name solely into the spouse’s name, which exempts it from any ineligibility period [42 USC section 1396 (c)(2)(B)(I)]. After the applicant begins receiving Medicaid benefits, the spouse transfers the ownership interest to the children, retaining an exclusive lifetime interest to live in the home. This interest is known as a life estate.

By retaining a life estate, the residence is no longer subject to the aforementioned lien, because the life estate would expire at the well spouse’s death. This allows the well spouse to live in the principal residence for the balance of their natural life. Furthermore, because a lifetime interest was retained by the well spouse, the children are deemed to have inherited the property for tax purposes (IRC section 2036). Although this means that the premises are included in the well spouse’s estate for tax purposes, it also means that the beneficiaries receive date-of-death value as their basis for income tax purposes (IRC section 1014).

Example. Althea passes away during 2003 with $500,000 in cash and a life estate in her home, which originally cost $25,000 but is currently valued at $400,000. The remainder interest in the home belongs to her children. For estate tax purposes, Althea’s gross estate equals $900,000, which does not cause any tax liability, because it is less than the 2003 AEA. Althea’s children now have an income tax basis in the home equal to the date-of-death value of $400,000. If the children sell the home, they would incur no taxable gain.

Finally, any real estate tax exemptions on the property due to Althea’s status as a senior citizen or a war veteran will remain during Althea’s lifetime. It should be noted that the fair market value adjustment to the basis of inherited property for beneficiaries outlined above will be limited when the estate tax is repealed in 2010 [IRC section 1014(f)].

Unanticipated plan costs. Although this strategy addresses both estate planning and elder care planning, it is not without pitfalls. For example, if the family unit decides after these transfers that current real estate market conditions dictate a sale of the premises during the well spouse’s life, negative tax consequences may result.

One negative consequence is that sale proceeds allocable to the well spouse’s life estate may be considered an available resource to fund the other spouse’s long-term health care. To determine this, it is necessary to calculate the current amount the well spouse is allowed to keep for their own support. This Community Spouse Resource Allowance (CSRA) in New York is currently a maximum amount of $90,660 [Social Services Law section 366 (C)(2)(d)]. The community spouse could petition Medicaid for an Enhanced Community Spouse Resource Allowance, but chances of getting the courts to overrule Medicaid’s findings are small.

Two possible strategies can be implemented to attenuate the reimbursement obligation. First, closing costs on the sale can be allocated to the life estate. This minimizes the proceeds attributable to the life estate, which are subject to Medicaid reimbursement. Second, in the event that the sale results in proceeds that are subject to nursing home costs, it may be possible to immediately transfer one half of the net proceeds attributable to the well spouse’s life estate to the children. This technique—commonly referred to as “the rule of halves”—effectively saves one half of the proceeds from the nursing home.

The second negative consequence of a sale is that a transfer from the well spouse to the children constitutes a completed gift of the children’s remainder interest for gift tax purposes. Treasury Regulations section 20.2031-7 determines the percentage of the real estate’s total value that would be deemed the transferee’s remainder interest depending on the age of the transferring life tenant. Furthermore, this gift would not be eligible for the annual gift tax exclusion of $11,000 per donee per year, because this applies only if the recipient has the present right to enjoy the property gifted. Because the children receive only a future interest to enjoy the real estate, the entire value of the remainder interest is subject to gift tax.

The $1 million AEA applies to the gift tax as well as the estate tax. Therefore, if the remainder interest is less than $1 million, and there were no prior taxable gifts made by the well spouse, there would be no gift tax due. However, it is still necessary to file a federal gift tax return (Form 709) by April 15 of the year following that of the transfer.

The final negative consequence is that upon sale of the residence during the well spouse’s lifetime, the income tax exclusion of a gain associated with the sale of a personal residence at a gain—$500,000 gain if married filing a joint return, $250,000 for all others—would be lost on the proceeds allocable to the remainder interest. Additionally, if the sale occurs during the well spouse’s lifetime, the cost basis to offset against the proceeds would be equal to the donor’s original cost basis, allocated between the life tenant and the remainder interests in much the same manner as the proceeds would be allocated.

Example. Julius, 70 years old, sells his home for $300,000. His original cost was $50,000. Julius has no taxable income arising from the sale, because it was his primary residence. However, if he had previously transferred the residence to his children while retaining a life estate, a sale during his lifetime would be split between his life interest and the remainder interests. Assuming his life interest was approximately 60% of the total value, $100,000 of long-term capital gain would be recognized by the children [($300,000--$50,000) ¥ 40%].

Irrevocable trust solution. By having the well spouse transfer the residence into an irrevocable trust, where the spouse would have no rights to the proceeds from a subsequent sale, the proceeds can be kept from becoming an available resource to pay for long-term care costs. For tax purposes, the transfer of the premises by the well spouse would not be classified as a completed gift, because it would qualify as a grantor trust pursuant to IRC sections 671–678. All income tax consequences are borne by the grantor, and the property is included in the grantor’s estate at death. This ensures that the remainder interests receive the grantor’s date-of-death value as their income tax basis. It also qualifies the residence for the $250,000 (or $500,000) capital gains exclusion, if it is sold while in the trust.

A word of caution is in order here. For Medicaid-qualifying purposes, transfers made to trusts are subject to an expanded 60-month look-back period. Thus, if the well spouse requires nursing home care, a transfer to a trust may impose an additional two-year waiting period when compared to an outright transfer to the children.

Primary Residence Transfer Between Spouses

As discussed, many individuals transfer their assets to family members in order to minimize their resources and maximize the chance of qualifying for Medicaid assistance. Although most of these uncompensated transfers trigger an ineligibility period, transfers between spouses are exempt, as described above.

Before making such a transfer, however, consider the potential income tax costs. Pursuant to IRC section 1012, for the purposes of computing gain on the subsequent sale of gifted property, the donee’s cost basis is considered identical to the donor’s cost basis. This may well have no tax consequence, should the asset sold be one’s primary residence at a gain that is within the exclusion amount. However, given current real estate valuations, there may still be significant income tax liability on such a sale.

Should the property be inherited by the spouse, IRC section 2040 provides that one half of property jointly held by a couple be deemed inherited. As outlined above, inherited property will receive a basis equal to the fair market value on the date of the decedent spouse’s death. Furthermore, if the residence was purchased prior to 1977, and the surviving spouse was deemed a nonworking spouse, a tax court decision has held that the surviving spouse is entitled to an inherited basis for the entire property, not merely one half. [Gallenstein, M. Lee v. Commissioner (1992), 70 AFTR 2d 92-5683, 92-2 USTC Par. 60114].

For example, Lawrence and Theresa are married. They bought a house in 1968 for $50,000, and made $50,000 of improvements over the years. The house is currently worth $1,200,000, and is their sole asset. Lawrence transfers his interest to Theresa before applying for Medicaid assistance. Six months later, Lawrence dies. If Theresa sells the house, there is a potential income tax liability of $170,000 (assuming a 20% combined effective income tax rate on the gain). This is calculated by taking the difference between the proceeds and the basis (cost plus improvements), then subtracting the $250,000 exclusion for single individuals and multiplying the net result by 20%. If this lifetime transfer was not made, and Theresa was a nonworking spouse, the income tax on the sale of the inherited residence would have been zero, because the date-of-death value of $1,200,000 would be Theresa’s income tax basis. The savings in this example far outweigh the Medicaid reimbursement.

It should also be noted that Medicaid pays a nursing home considerably less than private individuals for the same services, so that the Medicaid reimbursement claim is not as onerous as if one pays the nursing home directly (known as private pay).

Accelerated IRA Distributions

Income tax planning opportunity. One of the basic tenets of tax planning is to defer the recognition of income and accelerate deductible expenditures wherever possible; IRAs have traditionally offered qualifying taxpayers both of these advantages. Federal tax law mandates that taxpayers must start distributing the balance of their IRAs by April 1 of the year after they reach the age of 70 !s.

This distribution may be extended to a period of time equal to the combined life expectancy of the taxpayer and a designated beneficiary. The designated beneficiary is presumed to be 10 years younger than the taxpayer, regardless of their actual age disparity. If, however, the designated beneficiary is the taxpayer’s spouse and is more than 10 years younger than the taxpayer, then the actual age disparity may be used to determine the payout period. This results in an even longer payout period, lessening the amount to be included in the taxpayer’s income for the current year, and increasing the tax deferral.

Example. David, owner of a $1 million IRA, names his wife Elisa as the designated beneficiary. David reaches age 70 !s on January 10, 2003. The amount of his required distribution will be determined by dividing his IRA balance by the couple’s combined life expectancy. If Elisa is less than 10 years younger than David, their presumed age differential is 10 years, yielding a combined life expectancy of 27.4 years in 2003. The minimum required distribution would be $36,496. However, if Elisa is 15 years younger than David, the actual age differential would be used. This results in a longer combined life expectancy of 29.9 years, and a reduced minimum required distribution of $33,445 (Treasury Regulations section 1.72-9, Table VI).

Elder planning opportunity. Amounts contained within an IRA constitute nonexempt assets, meaning they must be spent down before qualifying for Medicaid assistance. However, once an IRA has begun to be distributed to the owner, it is considered an income stream rather than a nonexempt asset. In other words, even though the distributions would have to be used toward the long-term care, the remaining IRA balance is ignored when considering Medicaid qualification.

It is useful to note here that a taxpayer need not wait until reaching 70 !s to begin IRA distributions. Anyone can elect, without penalty, to take a periodic payment stream over their life expectancy, regardless of their age [IRC section 72(t)(2)(A)(iv)]. Once payments have begun, this should exempt the IRA’s balance from Medicaid ineligibility.

Howard Davidoff, JD, CPA, is an associate professor of accounting at Brooklyn College. He also maintains a practice on Long Island, N.Y., specializing in wills, trusts, estates, wealth preservation, and taxation.

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