Most people's most important asset is their home, and protecting it is always a priority. In your retirement, though, the threat of huge, unexpected medical bills is always present, and expenses like long-term care -- which Medicare and other regular health insurance plans typically don't cover -- can quickly wipe out your assets. To protect your home, some advisors recommending using what's known as a life estate. Let's take a closer look at what a life estate is and how using one could help you save your family home.
What a life estate is
The concept of a life estate goes back centuries, when property tended to stay within families for generations. A life estate gives a certain person the right to a home or other real property throughout that person's life. The life estate holder can choose to live in the home without having to pay rent to anyone, or can instead rent it out to others and keep the proceeds. However, the life estate holder has to pay the ordinary costs of maintaining the home, and must keep current on property taxes and other financial obligations.
When the life estate holder dies, the property then goes to the holder of what's called the remainder interest. The remainder interest holder automatically receives full legal title and possession of the property without going through further legal proceedings such as probate.
Creating a life estate is easy. The owner of the property can execute a deed that retains a life estate interest but gives the remainder interest to whomever the owner chooses.
Why life estates can be useful
The fact that life estates don't have to go through probate at death is an estate planning advantage of life estates that can greatly simplify the transfer of what in most cases is the most valuable asset in a person's estate. But estate planning isn't the primary reason why most people look into life estates. Instead, many use the concept as a way to safeguard the family home from creditors, especially Medicaid.
The most common issue that arises is that the costs of a nursing home or other long-term care eat away at a person's assets until they're gone. At that point, Medicaid eligibility usually kicks in, and Medicaid rules won't force you to sell the family home. What does happen, though, is that Medicaid puts a lien on the home; after the original owner dies, Medicaid is entitled to collect against that lien, forcing the sale of the home if necessary in order to collect the proceeds.
Creating a life estate effectively transfers the bulk of the home's property to whomever the person names to hold the remainder interest. As such, creating a life estate triggers rules that prevent the transfer of property to become eligible for Medicaid. But if you create the life estate at least five years beforehand, Medicaid's anti-transfer rules generally won't apply, because Medicaid only looks back that long to see what you've done with assets.
Life estates do present some challenges, though. One is that the creation of the life estate is treated as a gift to the remainder interest holder. That can trigger gift tax liability in some situations.
The biggest challenge is that the life estate holder can't sell the property without the permission of the holders of the remainder interest. Moreover, the proceeds of that sale have to be divided according to the relative value of the life estate and remainder interests. Otherwise, the government will see the arrangement as a sham, and you'll risk losing the benefits of the strategy.
Nevertheless, if you respect the form and substance of the life estate and follow all the legal requirements, you can generally preserve much or all of the value of your home for future generations. That's a benefit that's worth jumping through some hoops to get.
Legal concepts like life estates can be difficult to understand. But as a way of preserving a family home, life estates are relatively simple. Life estates don't make sense for everyone, but they can be useful in the right situations for those who understand everything that's involved.