Too often I will meet with a family after they have transferred their home without consulting a professional beforehand because they “don’t want the nursing home to take their home.” While transferring the home, or other assets, will protect those assets from Medicaid Estate Recovery if the previous owner ever receives Medicaid benefits during his/her lifetime, Estate Recovery is not the only concern here. Clients need to be cognizant about the tax consequences of transferring real estate during the client’s lifetime. There are 2 sections of the Internal Revenue Code that come into play when transferring primary residence: Section 121 and Section 1014.
Section 121 allows a taxpayer who has owned their home and used it as their primary residence for 2 of the past 5 years to exclude up to $250,000 of a capital gain. A married couple in the same situation can exclude up to $500,000 of a capital gain. When a parent gifts their primary residence to children, the children lose the Section 121 exclusion. This exclusion is lost because the children are not residing in the home. Even if the children were to reside in the home, the children need to own the home for 2 years after the transfer before becoming eligible for this exclusion. For example, a husband and wife transfer their home to their 2 children five years ago. They originally purchased the home for $50,000 and now the home is worth $550,000. Both children do not reside in the home full time. If the children decide to sell the home in the near future, they will owe capital gains on the $500,000 increase in the value of the property. Depending on each child’s tax bracket, the federal long term capital gains rate is between 15%-20%. The New Jersey capital gains rate is 9%. In the end, when the children decide to sell the home, the children will owe a combined $120,000-$145,000 in federal and state capital gains taxes. Yes, there will be no Medicaid Estate Recovery issue, but they caused a large tax liability in doing so.
Section 1014 allows the beneficiary of an asset inherited from the estate of a decedent to receive the asset at the value of the date of the decedent’s death. This is better known as receiving a “stepped up” basis of the asset. Using the same example above, except that the parents did not transfer the home to the children, if the husband dies leaving his half share of the home to his wife, the wife’s cost basis in the asset will increase from $50,000 to $300,000 (Current Value $550,000 – Cost Basis $50,000 = Capital Gain $500,000; Capital Gain $500,000*Husband’s Share in the home ½ = Amount Cost Basis is Stepped Up $250,000; Original Cost Basis $50,000 + Amount Cost Basis is Stepped Up $250,000 = New Stepped Up Cost Basis $300,000). If the wife passes away with the home in her estate her children as beneficiaries will receive a step up in basis to the current market value of the asset, in this case $550,000. If we use the example in paragraph 2 (parents transfer the home to the children during their lifetime), the children will not receive a stepped up basis and if they go to sell the home in the future, they will owe a large capital gain.
On the other hand, the issues above can be avoided with proper trust planning. A properly drafted trust allows the parents to keep the 121 exclusion, ensures the children will receive the step up in basis upon their death, and avoids estate recovery. Anyone looking to do long term care trust planning should consult with an experienced elder law attorney before doing so.