Gifts

Older adults are often concerned with preserving their homes from long term care costs. For many years, the solution has been to transfer their homes to one or more of their children. Doing so can be perilous for a number of practical reasons including the impact upon property in the event one of these children goes through a divorce, has issues with creditors, or predeceases their parents. On top of these concerns, one should be aware that giving a home to children can be beneficial to the government.

If a house is transferred outright to children, the government may be a beneficiary of this transfer for income tax purposes. Specifically, when a home is transferred outright, the children receive the transfer with what is known as a carryover basis. For example, Mom owns a home worth $400,000. She purchased it for $100,000 and put another $50,000 worth of improvements into the home over the years. Thus, the basis of the home is $150,000. If she transfers her home outright to her children, their basis for eventual capital gains taxation is $150,000. If the children sell the home for $400,000, they will have a capital gain of $250,000. Between federal and state capital tax rates, this may result in capital gains taxes of approximately $50,000. If Mom died owning the home, her basis would get stepped up to its value on her date of death. Thus, if the home is worth $400,000 on her date of death, the basis is stepped up from $150,000 to $400,000. If the home is sold for $400,000, there is no capital gain or capital gains tax.

To avoid capital gains taxes while endeavoring to preserve a home from long term care costs, many have transferred their homes to their children, but not outright. Instead, they transfer their homes with a reservation that they have a life estate in the home. The life estate, in short, retains the parent’s right to continue to live in the home until death. Because of this retained right, the home is counted as part of a parent’s estate when he or she dies for estate and inheritance tax calculations. However, it allows for the property to receive the aforementioned step up in basis upon death. Because many individuals who seek to engage in long term care planning do not have estates which are subject to estate or inheritance taxes upon death, the decision to transfer a home with the reservation of a life estate has often seemed simple.

There have been some risks in this strategy. If a home is sold during lifetime, the property is sold at its carryover basis and is thus subject to capital gains tax. Also, the State imposes an economic value of a life estate and requires that same be paid over to the life tenant and spent on long term care costs in order to obtain or maintain eligibility for Medicaid benefits. If the house is held until the parent’s death, the step up in basis has been received and there has been no payment required from the house, as it has been historically deemed that a life estate has no value at death – until now.

Earlier this year, an Ohio appeals court ruled that a deceased Medicaid recipient’s life estate does not extinguish at death for the purposes of Medicaid estate recovery. (See Phillips v. McCarthy, 55 N.E.3d 20 (Ohio Ct. App. 2016)) Estate recovery is a concept whereby each State is to recover from any assets of a decedent up to the amount Medicaid paid for his or her care during his or her lifetime. In this case, Lawrence Hess transferred his home to his three daughters and reserved a life estate. Eventually, he required nursing care and Medicaid paid for this care for about one year prior to his death. After the State put a lien on his former home, his daughters filed an action to quiet title and discharge the lien.

The appellate court agreed that common law does not value a life estate upon death. It also noted that a life estate was not explicitly mentioned in the federal legislation which mandated that each State create estate recovery acts in order to be able to receive matching federal dollars in which to administer its Medicaid program. However, it asserted that States, not the federal government, set forth the law regarding real property. Thus, it noted that Ohio, in its estate recovery act, included “life estates” as property which may be recovered at death. Whether the calculation of that life estate is made at the time of the gift or the age at the time of death is unclear.

What is clear is that transferring a home – with or without the reservation of a life estate – may be problematic. Before making this transfer, one needs to weigh the potential long term care costs which he or she may be facing with the potential capital gains costs which may eventually be incurred, as well as the amount of the property which may be held for estate recovery. Although New Jersey and Pennsylvania may not be enforcing a lien on life estates at this time, neither was Ohio when Mr. Hess transferred his home to his daughters. The right to collect against a life estate was not implemented until Ohio’s estate recovery act was amended. Thus, caution needs to be exercised in property transfers for long term care planning.

As wealth accumulates in this country and our population continues to age, the propriety of lifetime giving has increased. Gifts can be made out of sheer benevolence, but are also important in minimizing death taxes and long term care costs. This blog will review some of the key concepts involved in lifetime giving.

Gifts can be made by one of three sources: (1) an individual, (2) an agent under a durable power of attorney, and (3) a guardian. Gifts are made for a variety of reasons including, but not limited to, the desire to minimize estate taxes, the desire to minimize exposure to long term care costs, and simple benevolent intent.

When an individual makes gifts, which are subsequently disputed, the two main causes of action are lack of donative intent and undue influence. Many of the other grounds that can be utilized in a will contest, such as fraud, forgery, duress, and coercion, can be asserted as well.

The standard for donative capacity is generally seen as broader than that for testamentary capacity. The courts of the State have held that improvident giving may be construed as indicative of mental incapacity (See Pascale v. Pascale, 113 N.J. 20 (1988)). A reading of Pascale indicates that valid gifting must have four elements: (1) an act constituting actual or symbolic delivery of the subject matter of the gift, (2) an intent to give, (3) an acceptance of the gift, and (4) the donor’s relinquishment of ownership and dominion over the subject matter of the gift. Contests to set aside lifetime giving should reflect, where applicable, that the donor could not meet this test.

Undue influence can be raised as to lifetime giving as well. In a will contest, a presumption of undue influence arises when both a confidential relationship exists as well as suspicious circumstances. In the case of lifetime gifts, this presumption arises when there is a confidential relationship and a person in that relationship has gained an advantage due to that confidence. (See In Re Dodge, 50 N.J. 192, 227-28 (1967); Pascale v. Pascale, 113 N.J. 20 (1988)).

(a). Gifts by an Individual
When an estate planning attorney is assisting an individual in lifetime transfers, the same precautions utilized in screening testamentary capacity and undue influence in a will contest should be utilized. If litigation arises, the attorneys contesting or defending the gifts should explore the records of the estate planning attorney to ascertain whether or not any of these steps were taken.

(b). Gifts by Agents Under Powers of Attorney
Theoretically, gifts can be made under a power of attorney. However, there are a number of concerns which should be analyzed. First, the right type of power of attorney needs to have been executed. Specific powers, such as banking powers of attorney or real estate powers of attorney, do not cover gifting and thus cannot be used. Gifting should be acceptable if a general durable power of attorney is properly prepared. However, the mere fact that a document known as a “power of attorney” or “general durable power of attorney” is executed does not mean that gifting is allowed. In addition, the law generally prohibits self-dealing by individuals acting as agents under such powers.

When preparing a power of attorney, an attorney should carefully draft powers regarding gifting or creation of trusts on behalf of the principal. Such powers should discuss not only the fact that gifts can be made, but to what extent, for what purpose, and to what class of donees. Since spouses and children are typically the agents under such powers, the document should relieve the prohibition against self-dealing.

The aforementioned level of detail should be analyzed when an individual has gifted under a power of attorney. The general position of the Internal Revenue Service, which has been supported by case law, is that gifts for tax planning purposes cannot be undertaken under a general durable power of attorney unless specific language is included. As such, litigating attorneys should be reasonably able to assert that the absence of such provisions in a power of attorney used for gifting should void said gifts.

(c). Gifting By Guardians
Guardians frequently believe they have unlimited power. However, their authority to act is limited by the courts. It is possible that a guardian may be able to make gifts. However, gifting by guardians is clearly subject to two specific sets of rules. First and foremost, the statutory law of this State clearly mandates that gifting must be made pursuant to an order of the court. N.J.S.A. 3B:12-49 and 3B:12-50 clearly indicate that the court holds jurisdiction over transfers of the ward’s property. In addition, N.J.S.A. 3B:12-58 clearly states that gifting can be done only so long as the guardian can demonstrate to the court that the ward will be protected and that the individuals or entities which would be receiving gifts are the objects of the affection of the ward.

Second, any gifting must be made pursuant to the requirements of In Re Trott, 118 N.J. Super. 436 (Ch. Div. 1972). The Trott case, in relevant part, states that any gifting must be made proportionate to beneficiaries under the ward’s existing will or dispositive plan. In the absence of a will, trust, or other dispositive writing, the gifts will be made pursuant to the intestacy statute.

Note: The foregoing discusses the authority for gifts to be made by or on behalf of an individual. However, gifting is subject to laws effecting ordinary income, capital gains and gift taxes as well as issues regarding the propriety of making gifts to individuals who may have challenges such as special needs, marital problems and an inability to manage money. Thus, these concepts need to be addressed prior to gifts being made.

Muhammed Belal Hussain died on March 10, 2013 with a will, which left 50% of the residuary estate to the Hussain Family Foundation, 25% to the decedent’s surviving brothers, and 25% to the decedent’s surviving nieces and nephew. The Foundation did not exist at the time of the decedent’s death. The attorney who drafted the will advised the decedent that if the Foundation was not formed, the gift would lapse and the intended bequest would pass to the other beneficiaries. Subsequent to the decedent’s death, the Foundation was incorporated and the executor of the estate admitted that he expected to run and be paid by the Foundation. The petitioner, the decedent’s brother, asked the Court to find that the residuary bequest to the Foundation failed because the decedent never established the Foundation.

Cy pres is an equitable legal doctrine under which a court may reform a written instrument with a gift to a charity as closely to the donor’s intention as possible so that the gift does not fail. The petitioner argued that the doctrine of cy pres was inapplicable because such doctrine only should be invoked to modify the exact terms of a will to effectuate a general charitable purpose. Petitioner further argued that the will did not have a general charitable purpose, and even if the will had such purpose, the extrinsic evidence indicated that the decedent changed his mind.

The respondent executor argued that the Court could glean charitable intent from the will as a whole, the decedent’s visits to an orphanage in Bangladesh, and an earlier holographic will from 2006 which included charitable benefit wishes.

In light of the extrinsic evidence, the Court could not find a general charitable purpose, and instead found the cy pres doctrine to be inapplicable. In making its determination, the Court cited the fact that the decedent knew that the gift to the Foundation would lapse if the Foundation was not formed. The decedent was aware of this fact for four years and chose to not take action. In further support of its holding, the Court noted that the decedent only participated in modest charitable giving during his lifetime, but never enough to deduct the amounts from his tax returns. The Court explained the result may have been different had the will included more specifics as to the charity. Because the gift failed, the bequest to the Foundation passed to the other residuary beneficiaries. Thus, it is important that clients understand the implications of naming an unformed charity in their estate planning documents.

Questions regarding this article may be sent to Publications@Capehart.com.

Ten years ago, the landscape of asset protection or Medicaid planning changed dramatically with the passage of the Deficit Recovery Act (DRA) of 2006.  In relevant part, this act impeded prudent estate planning for individuals seeking to secure their assets from long term care costs by expanding the lookback period for gifting from three years to five years, and by deferring the calculation of any period of ineligibility so that it would not run until an individual’s assets were depleted.  It effectively created a minimum 5 year penalty for gifting which eliminated many of the middle class families whom both parties stress they are “looking out for” from even a modest amount of asset protection.

One protection which arose from this law, though, was what is known as a Medicaid annuity.  In essence, if an individual enters into a nursing home, his or her spouse who is remaining in the community, can keep the home, a car, and one-half of the liquid assets not to exceed $119,200.  However, if that spouse owns an Individual Retirement Account (IRA), he or she can convert same into an annuity, and keep that as well.

In order for the annuity to be accepted as exempt from being spent down for Medicaid eligibility, it must meet a variety of criteria.  It must be irrevocable, non-assignable, with immediate payout and actuarially sound among other requirements.  Over the past decade, many such annuities have been established and accepted by state Medicaid offices.

Over the past year, however, judicial intervention was necessary to avoid attacks by the States on this valid form of asset protection.   In 2010, Donna Claypoole entered a nursing home in Pennsylvania.  When her husband applied for Medicaid on her behalf, the Pennsylvania Department of Human Services denied the application stating that annuities were countable assets and must be spent down.  The U.S. District Court, on appeal, upheld the State’s determination declaring annuities “sham transitions”.

Fortunately, the Third Circuit reversed this decision. Zahner v. Sec’y Pa. Dep’t of Human Servs., 802 F.3d 497 (3d Cir. 2015). In doing so, it noted that Congress created a safe harbor under which certain annuities are not to be counted as resources in determining Medicaid eligibility.  The annuities purchased by the Claypooles qualified for this protection.   Thus, Medicaid annuities remain a viable asset protection technique.

Part 1: Types of Gifts

Throughout our lives, many of us desire to divest part of our estate to others.  There are variety of reasons for doing so including tax avoidance, protection against long term care costs, charitable inclination, and the mere desire to make family members and friends happy.  However, there are often certain perils in giving away assets including capital gains taxes, income taxes from deferred assets, gift taxes, loss of government benefits and economic issues facing a gift recipient.  A complicating factor in making gifts is that the laws affecting gifting and government benefits are inconsistent.  Thus, one must obtain prudent advice before making significant gifts.

One of the first principles to understand is how much can be given away during lifetime.  There are seven primary types of gifts: (1) annual exclusion gifts, (2) lifetime exemption gifts, (3) leveraged gifts of present interest, (4) leveraged gifts of a future interest, (5) gifts with a retained interest, (6) charitable gifts, and (7) gifts between spouses.  There are certain nuances in making many of these types of gifts.

The most popular gift, over the years, has been the annual exclusion gift.  Still commonly referred to as the “$10,000 gift”, it is actually a law that allows individuals to make gifts of $14,000 per person per year.  This type of gift can be given to as many different people as the donor wishes.  There are three exceptions or nuances to this rule.  First, a donor may fund a 529 plan up to five years at a time.  Thus, the donor can fund a plan with $70,000 in year one rather than spread it out over five years.  This allows a donor to not only relieve his or her estate of the principal given but all the income which would have been generated on that principal as well.  Second, payments for education may be made in any amount so long as they are made payable to the institution directly.  Third, payments for medical expenses are exempt so long as they are made to the medical provider and to the extent said expenses are not reimbursed by insurance.

The lifetime exemption gift is a provision which allows an individual may leave an additional $5,450,000, in the aggregate, to others during his or her lifetime.  These gifts arguably require the filing of a gift tax return on the 15^th of April in the following year in which they were made.  For example, if I made a single gift to my daughter of $64,000 to help her buy a home, $14,000 would be my annual exclusion gift and $50,000 would be reduced from my lifetime exemption.  So upon my death, I would only be able to leave $5,400,000 tax free.  However, I would not have to pay a gift tax now.

The third gift is what is called a leveraged gift of a present interest.  Historically, the most common gift of this type was a limited interest in a family limited partnership.  For example, if a father owned a farm, he or she would transfer the ownership of same into a partnership.  The father would become a general partner which would mean he would control the farm until he died if he wanted to do so.  He could transfer almost all of his economic interest in the farm to his children as limited partners.  Limited partnership would give the children an immediate interest as owners.  However, because they have no control over the business and cannot typically sell their interests while their father is alive, the government recognizes the argument that the value of the gift is not the same as a simple gift of cash with no strings attached.  As such, for example, if the father gave away, $600,000 of limited partnership interests to his children, the gift may be able to be discounted by 20%, or $120,000.  Thus, the countable part of the gift, for tax purposes, would only be $480,000.  The benefit of this gift is that the discounted portion escapes the donor’s estate gift tax free.  Similar gifts can be set up in limited liability companies and closely held corporations.

The fourth gift is what is called a leveraged gift of a future interest.   This gift is similar to the leveraged present interest gift in that it allows a discount to be taken on the value of actual gift made.  The typical structures used for these are Qualified Personal Residence Trusts (QPRTs), Grantor Retained Annuity Trusts, (GRATs), and Grantor Retained Uni Trusts (GRUTs).  For example, in a QPRT, a mother could give away her beach house to a trust.  By retaining the right to live there for a period of years after the gift, the value of the gift can be discounted as there is an economic value to that right and because the children do not receive the right of ownership until the future (i.e. the expiration of the period that the mother can live in the property).

The last three gifts are pretty straightforward.  A gift of a present interest in which a donor retains a right to the property occurs most typically in conveyances of real property in which a parent gives away a home to his or her children, but retains a life estate (i.e. the ability to live in the property until death).   Gifts between spouses are generally unlimited without gift tax consequences, thus being exempt from the annual exclusion and lifetime exemption rules.  Many gifts from charities are likewise exempt without limitation.

The next part of this article will explore other areas of gifting including capital gains and income tax ramifications.