Under current California Medi-Cal Regulations, the family residence is considered an “exempt asset” for purposes of qualifying the owner for state assistance under current law.  Owning or transferring the home does not preclude an owner from qualifying for Medi-Cal if he or she would otherwise qualify. However, if the property remains in the name of the Medi-Cal beneficiary/owner following his or her death, the property becomes a resource for Medi-Cal claims/liens.

This paper will discuss both tax and asset protection advantages of effectuating transfers of the family residence to an Irrevocable Asset Protective Grantor Trust.

Obviously, the owner could directly transfer or gift  the residence directly to a son or daughter, but such outright transfers without any strings retained by the transferor can produce not only unwanted tax consequences but loss of personal control. 

Advantages of Outright Gifting of the Exempt Residence:

1)       No period of ineligibility.

2)       Will not be an available resource upon death of the client.

Disadvantages of Outright Gifting:

1)       No step up in Basis under IRC code Section 1014 upon death of the client.

2)       If property is sold during the life of client/transferor, no IRC Sec. 121 exemption $250,000 for a single person $500,000 for a married couple.

3)       No asset protection from transferee’s creditor claims (divorce, bankruptcy, IRS liens, etc.)

4)       Client/transferor could be forced to move if child/Transferee sells or loses the property through improvidence, greed or forfeiture.

5)       If residence is transferred to grandchild or anyone other than spouse or child (and parent of grandchild is living), then there will be a loss of Prop 13 and the property would be reassessed for property tax purposes.

Grant Deed with Reserved Powers.  If the client wishes to retain greater control over the transferred property, the practitioner may consider recommending that the transferor retain special testamentary powers of appointment over the property as well as rights to remain living on the property following the transfer.  A power of appointment is equivalent to the power to disappoint an entitled or abusive beneficiary.  Please see Exhibit I for sample power of appointment language that could be incorporated in the Grant Deed.   A power to occupy the property and/or to lease the property for the life of the transferor insures that the client has a veto power over any future transfers of the property by the transferor(s).  Please see Exhibit II for a sample stand alone Occupancy Agreement.  An Occupancy Agreement could either be incorporated into the Deed instrument or be a stand alone document incorporated by reference in the transfer document.  By retaining a special testamentary power of appointment over the property, the client will not have made a completed gift for transfer tax, property tax, and income tax basis purposes (I.R.C. Section 1014).

This strategy also affords the Transferor’s continuing control over the property during his/her life.  To the extent he/she is not pleased with a child’s/grandchild’s conduct, and/or the beneficiary(s) has creditors or divorce problems then the grantor will have the power to alter his/her estate plan to conform to changed family circumstances.

The advantages of the Grant Deed with retained powers are:

1)       Income tax step-up in basis under IRC section 1014, 2036 or 2038;

2)       Grantor control over the ultimate disposition of the property during his/her life and at the Grantor’s; and

3)       Possible retention of the Prop 13 (no change of ownership) Property tax exemption if the property is transferred to a child or children of the Grantor.  (Proposition 58)

Potential disadvantages of the Deed with retained powers are:

1)       While the client (parent/grandparent) Grantor retains and Occupancy Agreement on the transferred residence, the creditors of the Transferee(s) may still be able to place liens on the vested remainder interest in the home during the Grantor’s life, or upon the death of the Grantor.  The retained special power of appointment prevents a “gift” from occurring on the transfer, but would not necessarily prevent future creditors or bankruptcy court trustees of the Transferee’s from making claims against the property in satisfaction of any indebtedness and third party judgment creditors, i.e., the Grantor only retained a power to alter the beneficiaries upon his/her death as to whatever remains of the property deeded.  And, if the property were sold during the grantor’s life, then the proceeds would also be subject to third party claims against the transferee(s).

2)       A sale of the property by the Transferee(s) during the grantor’s occupancy may not qualify for the IRC Section 121 Exclusion ($250,000 exclusion on capital gains).  The Transferee’s are now the ‘owners’ for purposes of California Property Law (even though the gift from mom/grandma was incomplete for gift tax purposes).

3)       If the property were sold (subject to the grantor’s approval or the approval of his/her agent under a Durable Power of Attorney) then the proceeds would be out of the control/use of the grantor and subject to the Transferee’s creditors, liens, divorce, improvidence, etc..

4)       By including on the face of the Deed a “retained personal Right of Occupancy,”  unwanted attention from DHS may become a concern if estate recovery issues arise.  Practitioners may wish to develop a stand alone “Occupancy Agreement” to avoid this drawback.

The California Irrevocable Grantor Trust.  The transfer of an exempt asset, such as the personal residence of a California individual, does not invoke any period of ineligibility for Medi-Cal benefits as explained in the foregoing discussion of a transfer of an exempt asset by Grant Deed.  And because the State of California has not adopted the Trust rules under OBRA 93, the transfer of the residence to a Irrevocable Grantor Trust should  be considered as an alternative or even primary protective strategy in the elder law practitioner’s arsenal.  

The authors have successfully employed transfers to an irrevocable grantor Trust for those clients whose homes are their primary asset and are concerned about Medi-Cal estate claims and recovery.

The advantages of this technique over the outright gift or gift deed with reserved powers are two fold:

1)      Greater control and flexibility for the Grantor

2)      Greater asset protection of the home and/or proceeds from any sale of the trust property.

Grantor Control and Flexibility.  The trust can be designed to be a Grantor Controlled Trust.  The grantor could even be the initial trustee with the power to make distributions of principal and income to the children/grandchildren subject perhaps to an ascertainable standard.  If the grantor wishes to retain the income from the property (whether it will be sold or leased in the future) he/she could be the income beneficiary.  However, such income would be subject to a share of the cost for nursing home care if the grantor qualifies for Medi-Cal long term care benefits  (The trustee could control the amount of the trust income by investing primarily in securities that pay little if any dividends or current income).  The trustee should be given such investment flexibility to override the Prudent Investor Rules under the Revised Principal and Income act.

As in the aforementioned Gift Deed Strategy the grantor may wish to reserve those string powers for control, asset protection, and tax purposes, viz., (1) A special testamentary power of appointment to change or add beneficiaries; (2)  An Occupancy Agreement to ensure that the trustee or successor trustee honor the clients rights to remain in the property and the client’s ability to approve or veto any sale of the trust property.  The Occupancy Agreement should provide for the Grantor to pay all property taxes, maintenance and insurance to ensure the client’s home owner income and property tax benefits; (3)  If the grantor retains a right to the trust income, IRC Section 2036 will apply as well as IRC Section 677 causing the grantor to be the owner for transfer and income/capital gain tax purposes.  Even though the Grantor will be paying for all taxes and other property expenses attributable to the trust , the grantor will not be considered to have made additional gifts to the trust subject to Medi-Cal transfer penalty rules.

Trust Protector.  Many clients are concerned about the apparent inflexibility of the typical Irrevocable Trust.  Inherent in its irrevocability is the inability of the grantor to amend or change the terms of trust because of changes in a) family circumstances, b) tax laws; and 3) Medi-Cal regulations.  However, an independent third party (friend, accountant, attorney or financial advisor) or trust protector could be given powers under the trust to change the terms of the trust and/or its trustees if circumstances so warrant.  Some examples of such powers are set forth below:

1)      Power to Change Trust Situs - The trust protector could be given the power to remove the trust from the state if it were prudent to do so.  For example, a Trustee/Child moves to another jurisdiction and/or the Grantor wants to move to another state to be near his or her caretaker, or the Trustee or Grantor wish to take advantage of favorable Tax/Medi-caid laws in another jurisdiction.

2)      Power to Change or Add Beneficiaries - The protector could be given the power to change or add beneficiaries within a given class depending upon a standard or philosophical point of view of the grantor as stated in precatory language in the trust declaration.  A clause such as, “The purpose of this Trust is to provide the beneficiary a proper education and motivation to be a productive member of society. I am attaching herewith a statement which is precatory and not mandated, that the trustee may use as a guideline for making or withholding distributions to a beneficiary.  In addition, the trust protector may be given the absolute discretion to modify the terms of the trust or add (limited to a class) or remove a beneficiary to comply with my intent and purposes as expressed herein.”

3)      Power to Remove and Appoint Trustee and Co-trustee - This power provides a safety valve for removal of an independent/or subordinate Trustee for a variety of concerns.  Examples include: (a) incompetency/incapacity, (b) under performing investment strategies, (c) misuse of trust funds, (d) charging excessive fiduciary fees, (e) Beneficiary creditor problems, (f) Beneficiary Transfer Tax Concerns - (Protector could add an independent Co-Trustee to a Beneficiary/Trustee controlled trust for the purpose of empowering independent Trustee to make all discretionary distribution decisions and the beneficiary/trustee retain all other distribution, fiduciary and investment powers.)

4)      Power to opt out of and into The Calfornia Prudent Investment Rule or revised Principle and Income Act.

5)      Power to grant beneficiary general or limited power of appointment for transfer tax and/or control reasons.

6)      Power to lend assets to the grantor or a Trust beneficiary.  This power is very important for many grantors who feel insecure about transferring their primary asset during their lives.  The power to borrow trust funds provides the Grantor with a security blanket if there were a need for such funds in the future.  (Example: residence is sold and $200,000 of cash and securities now comprise the trust estate.)  The Protector could lend trust funds with or without security at an adequate rate of interest.  This stratagem invokes grantor trust status and by itself would not necessarily cause inclusion in the gross estate for estate tax purposes but would cause the grantor to be considered the owner of the trust income for Income tax purposes. ^[1]

7)      Power to create additional trusts for Grantor or Beneficiary.  If the grantor or a trust beneficiary should have special needs because of a disability, then the Protector should have the power to modify the terms of the trust or create a new trust to provide for the beneficiary’ s special or supplemental needs without jeopardizing any private or government benefits for which the beneficiary would otherwise be entitled.

California Property Taxes.  If the children are the primary beneficiaries of the trust then it is important to invoke the parent/child exception (Prop. 58) on the property tax Change of Ownership form upon the transfer of the residence to the trust.

If the grantor is the income beneficiary of the trust and has an Occupancy Agreement, the authors have successfully explained to the San Bernardino Assessor that this is an exempt transfer similar to the transferor retaining a life estate in the residence.  If the Grantor is not a beneficiary of the Trust and a child is not the current beneficiary, then the author’s have found that it is an up hill battle with the local assessors to argue there is no change of ownership.  The fact that the trust is a grantor trust for income tax purposes does not preclude the assessor from declaring there has been a change of ownership for property tax purposes since the income and property tax laws are not in pari materia.

IRC Section 121 Exclusion.  To the extent the Irrevocable Trust is a Grantor Trust for income tax purposes, the IRS has announced through a  Revenue Ruling and in at least two letter rulings that the grantor retains sufficient ownership interest in the residence to qualify for the Section 121 exclusion if the property is sold by the trustee.^[2]

Asset Protection for Children/Beneficiaries.  This article has focused on the asset protection and tax benefits of the transfer of a personal

residence to an Irrevocable Grantor Protective Trust.  Consider also the economic effects of the compounding and appreciation with respect to those assets that make up the trust corpus.  In Los Angeles County the mean value of a single family home is over $250,000.00 and seems to be appreciating at ten percent (10%) annually.  Such an asset if retained over an 8 year period could easily double in value affording the trust beneficiary(s) a substantial fund for their continued use and benefit.  Following the Grantor’s death, the trust could provide a source of rental income to the beneficiary(s); and, if the residence were later sold, the proceeds remaining in the trust could serve as a protective resource to meet the beneficiary’s current and future financial and investment goals.

If properly designed and structured, the trust can be controlled by the beneficiary and would not be subject to the claims of third party creditors, IRS liens, bankruptcy trustees, and divorcing spouses.  The Parents/Grandparents who have created a protective trust for the family residence have done so to protect it from third party creditors and a Medi-Cal claims.  Why would they not want to do the same for their heirs? 

Following the death of parents/grandparent/Grantor(s), the irrevocable trust could then simply continue for the benefit of the children and their issue.  The trust could be designed to divide into as many sub-trusts as there are then living children.  Each child could then be the trustee or co-trustee of his or her own trust share.  If the property at the Grantor’s death is valued at $500,000.00 (assume two children are the surviving primary beneficiaries), each child will have $250,000.00 in his or her separate trust to invest and use the trust funds for his/her health, education and support. and/or to have the trust purchase real or personal property for the child’s use and enjoyment.