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Can You Borrow on a Life Estate?

life estate - margolis-bloom-dagostino-wellesley-estate planning

One of the principal planning techniques to protect a home from the potential costs of long-term care is to put it into a life estate. Like anything else in the law, life estates have their benefits and consequences.

What Life Estates Are All About

A life estate is a form of co-ownership of real estate under which the so-called “life tenant” has total rights to the property during their life and the so-called “remaindermen” become the sole owners upon the death of the life tenant. The life tenant has the sole right to occupy the property during their life and if it is rented out, they receive all the rental income. They also have the obligation of maintaining the property. It’s possible to have two (or more) life tenants. For instance, a husband and wife might convey their home into a life estate that continues until the second of them has passed away.

Neither the life tenant nor the remaindermen can sell or mortgage the property without the cooperation of the other since they all must sign the deed or mortgage paper. If the property is sold, the proceeds are distributed based on the age of the life tenant and current interest rates. The older the life tenant, the smaller the value of their interest since they are likely to occupy the property for fewer years. On the other hand, the higher the interest rate, the larger the share of the proceeds attributed to the life tenant, since current ownership is accorded more value if it can produce more interest.

Valuation of Life Interests

The Internal Revenue Services provides tables valuing life estates based on ages and interest rates. For instance, if the prevailing interest rates are 2% and the life tenant is 65 years old, their interest is deemed to be 28.6% of the property value and the interest of the remaindermen 71.4%. If the life tenant is 85 years old, their interest is only 11.2% and the remaindermen’s 88.8%. The recent increase in interest rates has significantly increased the value of life estates. At a 4% rate of interest, the life tenant’s share of the proceeds of a sale of property increases to 47.2% for a 65-year-old and to 20.5% for an 85-year-old.

MassHealth was not happy with the meager share of proceeds of sale going to life tenants when interest rates were low. This is because when nursing home residents sell property they must pay privately for their care until their share of the proceeds are spent down. If only a very small share of the proceeds go to the life tenant who is in a nursing home, only a small amount needs to be spent on their care and it’s likely that MassHealth will have to pick up the cost of their care much sooner. The funds going to the remaindermen are protected.

As a result, MassHealth requires beneficiaries to use a table created by the Social Security Administration in 1999 when interest rates were higher. It accords a 65-year-old 68.0% percent of the proceeds of sale and an 85-year-old 35.4%. This is still a greater percentage than the IRS tables at a 6% rate of interest, but could be less than the IRS tables if prevailing rates keep rising.

Also, be aware that the IRS provides tables where there are two life tenants which calculate the value of their joint life interest. MassHealth does not appear to do so. Further, the creation of the life estate is considered a transfer of assets which can cause the grantor to be ineligible for MassHealth for up to five years. Given the structure of this transfer penalty, most applicants are ineligible for the full five years. However, there are some instances where the transfer penalty may be shorter based on the value of the transferred property. In such cases, the MassHealth tables can in fact be favorable to the applicant for benefits because the reduce the value of the transferred property and thus the length of the period of ineligibility.

Mortgages and Reverse Mortgages

As is mentioned above, it’s possible to take out a mortgage on property in life estates as long as all the life tenants and remaindermen sign the appropriate papers. Typically, the proceeds of the loan would be distributed to the life tenant and the remaindermen according to the IRS tables, unless MassHealth is involved, in which case it would be advisable to use their tables. However, if all the owners agreed, the loan proceeds could be distributed differently. For instance, if the owners were borrowing to raise funds to pay for home care for the life tenants, they could allocate all the proceeds to them.

On the other hand, if they allocated more of the proceeds to the remaindermen than the share provided for in the table used by MassHealth, the excess amount would be deemed a transfer of assets causing a period of ineligibility for MassHealth.

Reverse mortgages are treated a bit differently from standard mortgages with all the proceeds being allocated to the life tenant. As explained by Stephen R. Pepe, JD, a Reverse Mortgage Consultant with Longbridge Financial, LLC:

The life tenant is the reverse mortgage borrower. The remaindermen are mortgagors on the mortgage but they are not borrowers. The remaindermen need not be eligible reverse mortgage borrowers. We assess the eligibility of the life tenant only.

When calculating the size of the reverse mortgage, we consider the home’s fair market value, not just the IRS value of the life estate interest. So it is possible for a very old life tenant to acquire a reverse mortgage that is larger than the IRS valuation of his or her life estate interest.

Conclusion

In short, life estates can be very useful long-term planning tools and even allow the life tenant to borrow funds to pay for care. As compared to irrevocable trusts, they have both benefits and consequences which are beyond the scope of this article to explore.

However, one note: One of the potential downsides of life estates is that they can be relatively rigid. Once the grantor creates the life estate naming remaindermen, they normally cannot change them since they become owners of the property. This can be problematic if they have a falling out with a child, a child runs into financial difficulty, a child passes away, or a child refuses to cooperate in getting a mortgage or reverse mortgage. In our practice we mitigate this at least to some effect by giving the grantor the right to change the ultimate beneficiaries by directing the property to others through their will, a so-called testamentary power of appointment. This can be very important in case of changes in circumstances and to give the grantor more control.

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