There are two relatively easy ways to transfer title to real estate at death while avoiding probate and the tax trap often created by an outright gift of real estate. These two methods of conveyance can also be used to avoid a Medicaid lien. However, neither of the deeds discussed below can eliminate the need for a will. Get legal advice before using either of the two deeds discussed below.
Families will often decide to simply gift real estate to children and other family members for various reasons but the most common reason is to avoid probate. Before you gift real estate you must be aware of the potential problems this can cause.
Substantial tax issues can arise with an outright gift, especially if the property has appreciated in value while owned by the donor (the person making the gift). When property is gifted before death, the person receiving the property, the grantee, takes the same tax basis as the donor. This can cause a substantial tax liability when the property is eventually sold. Let me illustrate this with a hypothetical. Assume the parents paid $50,000 for the property, lived in it for thirty years, and it is now valued at $300,000. The parents paid $50,000 for the property so that is their tax basis, assuming they made no capital improvements over the years. If they gift the property to their child, the tax basis of the child is also $50,000.00 so when the child sells the property, his taxable gain (sales price less taxable basis) is $250,000.
If the property passes to the child because of the death of a parent, the tax basis in the child would be increased, or stepped up, to the market value of $300,000. The tax on the increase in value of the property while it was held by the parents is eliminated. In this hypothetical, that would mean that $250,000 (the difference between the purchase price of $50,000 and the market price of $300,000) would be eliminated if title to the property does not pass until the death of a parent.
Another disadvantage of an outright gift of valuable property is that if the gift is greater than $15,000 (this is the amount in 2019 but it is indexed and will increase with inflation) a gift tax return will be required although the donor likely will not actually pay a gift tax.
If a transfer is made in anticipation of the need for Medicaid assistance for nursing home care, an outright transfer may disqualify the person making the transfer for several years, but keeping the property may subject it to a Medicaid lien after the death of the person receiving Medicaid assistance for nursing home care.
If Medicaid provides financial assistance for nursing home care, after the Medicaid recipient dies, Medicaid has an automatic lien on deceased person’s estate. There are some exceptions but for most people, Medicaid will have a lien which arises only after the death of the recipient. The Medicaid is collected during probate. If you can transfer title to real estate without probate, the claim can be avoided.
Fortunately, there are two ways to make a gift of property now but delay the actual transfer of title until the death of the donor. That allows the transfer document to be signed now but it avoids the potential tax penalties discussed above and it can avoid or reduce the amount Medicaid can recover from the estate of a deceased person because title to the property passes at death without probate.
Lady Bird Deed
Lawyers often use the term “enhanced life estate deed” when referring to this particular deed but the common street name, at least in Texas, for the deed is a “lady bird deed” and I will use that terminology here.
Many readers may not be familiar with the term “life estate” so let’s discuss that first. A life estate is the right to use and enjoy property for the remainder of the life of the person receiving or reserving the life estate. A common way of creating a life estate is to simply deed the property to someone, perhaps the donor’s adult child, while reserving the right to continue to use, rent, and/or occupy the property. When this deed is used, the deed conveys the property but reserves a life estate. The property actually conveyed is called the “remainder interest”. If this deed is used, let’s call it a “standard life estate deed”, the tax problems discussed above are triggered because there has been an actual conveyance of property. Both the life estate interest and the remainder interest have a value. I’ll not discuss how the Internal Revenue Service calculates those values because it is unnecessary for our discussion.
There is a way to “enhance” a “standard life estate deed” to avoid the tax issues. If the deed reserves to the grantor (the person making the transfer) the right to mortgage, lease, sell, or terminate the deed without the approval of the grantee (the person receiving the transfer) or anyone else, the IRS takes the position that no actual gift has occurred until the grantor dies without having revoked the deed and the grantee is entitled to the stepped-up basis discussed above. When a lady bird deed is used, the grantor retains possession and use of the property, including the right to rent it and receive the proceeds and retains the enhanced rights discussed above including the right to terminate the deed. However, if the grantor dies without having revoked the deed, title passes to the grantee without the need to probate the estate because the life estate in the grantor terminates automatically at the death of the grantor.
Transfer on Death Deed (TODD)
In 2015 Texas approved the use of transfer on death deeds. The effect of the transfer on death deed is much the same as a lady bird deed. It can be signed and recorded now by the grantor but the actual transfer of title does not occur until the death of the grantor. Since title does not transfer until death, it, like the lady bird deed, avoids the tax trap associated with an outright gift. However, a number of title insurance companies are refusing to insure based on a transfer on death deed. They are imposing substantial post-death requirements when the TODD is used.
Comparison of Transfer on Death and Lady Bird Deeds
Although the two deeds are similar, there are substantial differences:
- TODD’s are new in Texas and there is not a large body of judicial decisions interpreting them. This creates uncertainty that is not present with lady bird deeds.
- A TODD cannot be signed using a power of attorney while the lady bird deed can.
- The beneficiary of a TODD must survive the grantor by 120 hours. If the beneficiary does not survive for at least 120 hours, the property will be subject to probate. This is not required with a Lady Bird Deed.
- A Transfer on Death Deed is subject to some claims against the estate of the grantor for two years after the death of the grantor. Using a lady bird deed eliminates this risk.
- Texas title companies impose more conditions when a TODD is used than when a lady bird deed is used. Since the property is subject to creditor claims for two years after death, some title companies may refuse to insure title for two years after death. If they agree to insure title, they will likely require proof there are no estate or inheritance taxes owed by the estate, and that the donor (deceased person) has no unpaid debts. These issues are eliminated when a lady bird deed is used.
The primary substantive advantage of the lady bird deed over the TODD is that it avoids claims against the estate for the two-year period post death and the title problems that may result from this. The inability to use a power of attorney to sign the deed and the 120-hour survival period may, sometimes, present problems, but for the most part either of these two deeds will avoid the tax and Medicaid issues discussed above.
Unless there is a reason a lady bird deed cannot be used, we favor those deeds over TODDs.