A deed with a life estate is an estate planning tool with many advantages. The first advantage is a very significant tax advantage. If an elderly person wishes to have certain persons receive their real property upon their death, instead of leaving it in a will, they can transfer the Deed to the beneficiaries, retaining a life estate for themselves. Upon their death, the property automatically goes to the beneficiaries, without having to probate a Will. By reserving a life estate, the grantor need not worry about having to leave the home, since they have the right to stay there for the rest of their lives. Upon their death, the property is transferred with a stepped-up basis. This means that if the property increased in value (which can be significant), the heirs receive the property with a market value basis, and if the house were sold within six months of the date of death, no capital gains tax would be due. Any increase in value from the date of death would be considered capital gains from that point onward. An accountant should be consulted with any tax ramification questions, whether it be regarding capital gains tax or estate or gift tax questions. For example, the laws regarding a step up in basis are different for the year 2010, and an executor has certain options, the decision for which will depend on the value of the estate.
The laws regarding life estates with respect to Medicaid changed last year. It appears that there will be a look back period for qualification even when a life estate is retained, although it is calculated differently than when a life estate is not retained. There will also be a Medicaid lien for the value of the life estate. This is a very specialized area of law, and an attorney should be consulted before taking any action toward qualifying for Medicaid, or transferring any property to become qualified for Medicaid.
It may be a disadvantage to transfer the property to a life estate if it's expected that the property will be sold prior to the death of the parent. This is because the capital gains exclusion upon sale may be lost, unless the new owner qualifies for that exemption.
If the property is transferred outright, without a reserved life estate in the deed, the IRS may still consider that it is a retained life estate if the parent remained in the premises, without paying rent, and other crieteria. Hence, the property would be includible in the estate, and the stepped-up basis allowed.
In addition, subject to verification with your property assessor’s office, it looks like a senior citizen will be able to retain their senior enhanced Star property tax exemption even after transferring the property and retaining a life estate, so long as they reside in the property.
Cynthia M. Burke, http://www.nyrealtylaw.com