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INCOME ONLY TRUSTS: HAVING YOUR CAKE AND EATING IT TOO

INCOME ONLY TRUSTS:

HAVING YOUR CAKE AND EATING IT TOO

Recently a healthy single woman came to my office with the following demand: “Protect my money in case I ever enter a nursing home, make sure my children do not pay any capital gains tax on the appreciation of the assets, and protect my dignity and self-respect so that I do not have to go my children and ask for money every time I need it.”

The woman’s assets included a home which she and her late husband had bought over thirty years ago for $45,000.00 and is now worth approximately $500,000.00. She also has stocks and bonds in the amount of $600,000.00 which were purchased for $80,000.00. I proceeded to enumerate the three options available to her and the consequences of each.

WAIT & SEE” APPROACH

This first option is also known as the “do nothing” alternative. Here, the client’s hope is that she will never need long term care. If it is eventually required, she will do something about it “when the times comes.” This usually results in the senior citizen spending all of her hard-earned assets on nursing home care. Clients and family members lose greatly and are often left with nothing, while the nursing homes are the big winners.

GO ALL OUT” APPROACH

This second option is where the client transfers all of her assets to her children, without considering capital gains tax and nursing home penalty periods. The children now own these largely appreciated assets, but upon any sale, will suffer a 20% tax hit, in the amount of $195,000.00.

Furthermore, several risks are associated with an outright transfer to children. If the children were to divorce or declare bankruptcy, the client’s money would be used to satisfy the claims of the children’s creditors. Additionally, if the client needed nursing home care immediately, that money may not be available to her, since it now legally belongs to her children. Here the client certainly loses her dignity by asking her children for money as she needs it.

INCOME ONLY TRUST

The third strategy is the course of action the client selected. Income Only Trusts provide a wonderful planning opportunity for both single and married couples who wish to protect their appreciated assets from the nursing home, while at the same time retain control over the income.

Clients who wish to protect their hard earned assets from future nursing home care usually list several factors why they decide to create a trust rather than transfer the assets to children outright. Control is one of the top reasons cited by clients. By transferring the assets to an Income Only Trust, as opposed to an outright transfer to children, the client has more control over the assets, since income is being paid directly to the grantor, rather than to the children. The client feels a greater sense of independence because of this direct payment.

In order to ensure that the assets in the trust are protected from the nursing home, the trust must be irrevocable. The grantor retains the right to receive income but the principal can not be accessed. For Medicaid planning purposes, the five year lookback period begins when assets are transferred into the trust. When assets are transferred from this trust to third parties, no lookback period is imposed because the penalty had been imposed when assets were placed into the trust.

Another reason not to transfer assets directly to children is to avoid some potential risks. If the child has creditors, gets divorced or has certain types of bad habits (gambling, drug addiction, alcoholism, and the like), the assets in the child’s hands may be squandered and will no longer be available to the parent. These risks are not found when creating an Income Only Trust, because the assets only belong to the Trust and not the child, and can’t be attached by the child’s creditors or divorcing spouse, or squandered due to the child’s bad habits.

Tax implications also warrant the use of an Income Only Trust. Since the income flows back to the grantor, the parent will be taxed on the income at the parent’s lower tax rate. Furthermore, if appreciated real estate is placed in the trust, the $500,000.00 exclusion from capital gains tax on the sale of the principal residence is preserved if sold by the trust; it is lost if the house is transferred directly to child who then sell it. From a capital gains tax perspective, the appreciated assets placed into this trust would be included in the client’s estate upon her death. Thus, the children will receive a step-up in basis and avoid paying significant capital gains taxes.

Income Only Trusts can be used in crisis planning but are even better in situations where it does not appear that Medicaid will be needed for a considerable period of time. The Deficit Reduction Act of 2005, signed February 8, 2006 created a five year lookback period for nursing home Medicaid eligibility for both transfers to individuals and to trusts. As a result of this level playing field, many clients have chosen to establish an Income Only Trust, if it is anticipated that Medicaid nursing home will not be required for five years, or if the Medicaid penalty period is less that the look back period.

The sole pitfall using this trust is that the State may seek to recover against the principal, to the extent of payments made by Medicaid on the grantor’s or spouse’s behalf. To prevent this from happening, the trust must terminate before the grantor or spouse applies for Medicaid. Distributing the principal to the beneficiaries during the grantor’s or spouse’s lifetime will not create a penalty as the gift was made when the trust was created. Distributing the income to the beneficiaries during the grantor’s or spouse’s lifetime will create a penalty but only on the income that is foreclosed to the grantor or spouse.

In summary, a properly drafted Income Only Trust is a marvelous planning technique that is easier for clients to accept than outright transfers to children. By properly drafting an Income Only Trust, I can ensure that your money will be protected from the nursing home, your children will not pay significant capital gains tax on the appreciation of the assets, and your dignity and self-respect will be preserved. This way you and your family members are the big winners!

THE BENEFITS OF A PERSONAL RESIDENCE TRUST

THE BENEFITS OF A PERSONAL RESIDENCE TRUST

 

HOW TO BEST PROTECT YOUR HOME IF NURSING HOME CARE IS EVER NEEDED

 

By: BENJAMIN D. ECKMAN, ESQ.

Elder Law Attorney

 

Many senior citizens are concerned with the thought “what will happen to my primary residence if nursing home care is ever needed?” Married couples are afraid that if one spouse enters a nursing home, the other spouse (“the community spouse”) will have to sell the house. Widowed and single individuals are worried that if they enter a nursing home, they will lose the ability to transfer their house to their children or other loved ones. Fortunately, with proper planning, protection of the primary house is almost a certainty.

 

Many married couples own their homes jointly with one another. If one spouse enters a nursing home, the other may still continue living in the house. However, if the couple wishes to preserve the home for the family, planning must be done. Consider this frequent example: Husband has a stroke and needs permanent care in a facility. Wife can continue to reside in the marital home. However, if the wife predeceases her husband, the home, which had been owned jointly, will now pass entirely to the husband. Since no planning was done, the house will be sold, and such proceeds used to pay the husband’s nursing home costs.

When a widowed or single individual seeks governmental benefits, Medicaid requires that their available assets be below $2,000.00 before receiving assistance. Moreover, if a person enters a nursing home without a reasonable expectation of returning to the primary residence, Medicaid will insist that the home be sold and the proceeds used to pay for care. Some seniors believe that they can simply transfer the home to their loved ones prior to entering a nursing home. This is incorrect, as Medicaid examines all gifts made within five (5) years of applying for the program. Accordingly, such a transfer will result in a penalty period for which Medicaid will not cover nursing home costs.

 


THE SOLUTION: THE PERSONAL RESIDENCE TRUST

            Fortunately, various planning techniques still exist to protect the family home. “The Personal Residence Trust” is one of the most commonly used asset protection planning strategy. In this instance, the Grantor (homeowner) signs a Trust document and a new deed is also signed, re-titling the house in the name of the Trust. The Grantor retains the right to use and occupy the property for the rest of his/her life. This means that the Trust now owns the home, while the grantor retains the use and occupancy for the rest of his/her life. This transfer starts the look-back period for Medicaid. So long as the 5 year look-back period elapses, the primary residence will be protected from the nursing home.

 

From a practical perspective, the Trust assures the Grantor that little has changed. The Grantor (usually the parent) is still legally obligated to pay all expenses of regular maintenance, upkeep, and property taxes, and can deduct these items as well. The Grantor is entitled to exclusively occupy the premises, without fear of being evicted. Upon the parent’s death, the house in the trust is transferred to the trust beneficiaries, all in accordance with the parent’s wishes.

 

Medicaid Look Back Period

The transfer of the home to the Trust is a gift for Medicaid purposes. The five year look-back period starts when the deed is recorded with the county clerk. The look-back period is the time frame within which Medicaid can examine any and all gifts. For those who think they are healthy and will not need nursing home care within the next 5 years, a transfer of a house to a Personal Residence Trust can be a grand slam as the house usually is the most valuable single asset.

 

Tax Issues

What happens from a tax perspective as the Trust now owns the house?  The Grantor gifted an asset but retained the right to use and occupy that asset. This use and occupancy string pulls 100% of the home’s value into the Grantor’s estate. From an income tax perspective, if the property is sold during the Grantor’s lifetime, the Grantor will be entitled to the $250,000.00 capital gains tax exclusion, ($500,000 for married couple).

 

From an estate tax perspective, 100% of the value of the house is included in the Grantor’s estate, and the beneficiaries / children will receive a “step up” in basis on the death of the Grantor, equal to the fair market value at that time. For example, assume Mom bought the house for $40,000 in the 1960’s and it appreciates to $440,000 at the time Mom passed away. Mom’s estate includes the house valued at $440,000, and her heirs get the house with a $440,000 basis. Suppose they later sell the house for $450,000. They will pay capital gains tax on only $10,000.

 

Only if the total estate exceeds $675,000 (New Jersey) or $5,430,000 (Federal), will there be an estate tax. If there is a New Jersey Estate Tax, the top graduated rate is 16%; this is far less that the new capital gains tax rates that would apply if Mom simply gave the house to the children outright without creating the Trust.

 

New Jersey imposes an Inheritance Tax on beneficiaries who are not children. Assume, for example, Uncle establishes a Trust, naming his nieces and nephews as beneficiaries. Whereas the Estate Tax is imposed on the value of the decedent’s estate, the Inheritance Tax is assessed against a beneficiary based on their relationship to the decedent. Transfers to spouses and children are exempt, while transfers to other family members are not. When Uncle dies, the entire value is subject to Inheritance Tax. Thus, the nieces and nephews get the house, but will pay 15%-16% of its value to the NJ Division of Taxation. The Inheritance Tax is a credit to the Estate Tax, preventing the estate from paying both taxes.

 

Real Estate Taxes

The Grantor of the Trust is responsible for paying the real estate taxes. Once the deed is signed and filed with the County Clerk, a copy is provided to the Municipal Tax Office. This office will update its records, listing the Trust as the owner, sending the tax bills to the house in the Trust’s name. The Grantor continues to receive certain tax benefits provided to New Jersey homeowners. The real estate taxes can be deducted, and the New Jersey Homestead/New Jersey Saver Rebate, the Senior Citizen’s Deduction and the Veteran’s Deduction, if applicable, can all be maintained.

 

Since the Trust now owns the house, if the home is sold during lifetime, the Grantor would not be entitled to any portion of the sale proceeds. It must stay in the Trust. However, the Trust can buy another property and give the Grantor the use and occupancy rights in the second property.  If the home is rented, the rental income would pass to the Trust. This is a great benefit as Medicaid could not count the sale proceeds or rental income toward the cost of care.

Medicaid Liens and Estate Recovery

The regulations governing Medicaid estate recovery are complex. The basic rule is that if an individual has been a recipient of correctly paid Medicaid benefits, then upon that recipient’s death, the state may recover those benefits from the recipient’s estate. No recovery exists if the recipient leaves a surviving spouse, child under age 21, or blind or disabled child.

 

The Medicaid Estate Recovery Unit has interpreted the estate recovery statute to apply only to life estates created by will rather than by deed. Thus, a transfer of assets to the Personal Residence Trust while retaining the use and occupancy is one of the most ideal asset protection planning technique.

 

Conclusion

To determine if the Personal Residence Trust planning technique makes sense to protect your assets from the skyrocketing nursing home costs, you must be proactive as the five year lookback period starts when the deed is recorded. Please contact our office to schedule an appointment and get professional legal advice for your situation. You will begin the process of ensuring more of your hard earned assets pass to your family members, not the government or nursing home.