Protecting the Home Through a Special Power of Appointment

The following article first appeared in the February 1996 issue of The ElderLaw Report.

Protecting the Home Through a Special Power of Appointment

By Alexander A. Bove, Jr.

The home is usually not only the most valuable asset owned by the family facing long-term care, but the most cherished one as well. It is also the only major asset an individual or his or her spouse can retain while still qualifying for Medicaid. As a result, practitioners are constantly seeking ways to protect the home from either the disqualifying transfer rules or the reach of estate recovery. Practitioners also seek to mitigate the tax consequences if the home is sold either before or after the Medicaid recipient's death.

A creative idea that can satisfy virtually all of these objectives may lie in the transfer of the home with retained special powers of appointment.

Scope of the Power

A special--sometimes referred to as "non-general"--power of appointment is one that cannot be exercised in favor of the holder of the power, his creditors, his estate, or the creditors of his estate. Restatement of Property, Second, §11.4. A typical special power might provide that the holder of the power can appoint to any one or more of his lineal descendants. But the power may be much broader than that and still be a special power. That is, the holder may have the power to appoint to anyone in the world except himself, his creditors, his estate, or the creditors of his estate. Despite the extent of this power, it is still considered a special power, unreachable by creditors of the holder. Restatement of Property, Second, §13.1. The power is exercisable during the holder's lifetime (by a deed), or at the holder's death (through his last will), or both, although it can be irrevocably exercised only once.

Federal tax laws provide that a transfer of property where the transferor retains a special power of appointment is not a completed transfer. Treas. Reg. 25.2511-2(c). Therefore, even though the transferor has legally disposed of the property, the transferred property is treated in every respect as if it still belonged to the transferor (the holder of the retained power) for income, gift, and estate tax purposes. In addition to the clear confirmation of this concept in basic principles of taxation reflected in the tax regulations, it has been repeatedly confirmed by the courts in an exhaustive list of cases. See, e.g., Corliss V. Bowers, 50 S.Ct. 336 (1930).

The Best of All Worlds

Interestingly, in most of these cases the taxpayer transferor sought to shift the tax burden to the transferee, while retaining certain powers or enjoyment over the transferred property. In the Medicaid context, however, we seek to do just the opposite where the home is concerned. The two reasons for seeking to retain tax ownership are the "over 55" capital gains exclusion and the step-up in basis at death. That is, we seek an arrangement where we can have the best of all worlds: a completed transfer for Medicaid purposes that starts the disqualification period running, while at the same time retaining the right to the $125,000 capital gains exclusion if the property is sold during the transferor's lifetime and the right to a step-up in basis on the death of the transferor if the property is not sold. And, as frosting on the cake, wouldn't it be great to have an arrangement that totally avoids exposure to the estate recovery rules? Impossible? Not at all.

For Medicaid purposes, it is clear that a transfer of property where the transferor cannot ever recover the property for his own benefit is a completed transfer. 42 U.S.C. §1396p(d)(3)(B)(ii), and HCFA Transmittal No. 64, §3259.6(c), and note that since no trust is involved, the look-back period is 36 months, not 60 months. * For tax purposes, however, as stated above it is equally clear that, despite the transfer, the transferor will continue to be treated as the owner of the property. Thus, where an individual transfers his home to, say, his children, reserving special lifetime and testamentary powers of appointment, he has made a disqualifying transfer (assuming the transfer is not exempt), but on the transferor's death, the property will be includable in his estate and be subject to a step-up in basis. IRC §§2038 and 1014(b)(9).

Establishing Ownership and Use

What about a sale during the transferor's lifetime? To be eligible for the "over 55" capital gains exclusion, the taxpayer must have owned and occupied the property as his principal place of residence for the required period. IRS §121(a). The IRS has repeatedly held that the term "owned" in this case includes tax ownership, in addition to the traditional concepts of legal title. In the landmark revenue ruling on this point (Rev. ruling 85-45, 1985-1C.B., 183), legal title was held by the trustee of a trust; nevertheless, the beneficiary was treated as the "owner" of the property for tax purposes. Similarly, where the transferor holds a retained special power, legal title is in the named transferee, but the powerholder is still treated as the owner for tax purposes. Therefore, there should be no question about satisfying the ownership requirement. But what about the requirement for occupancy or use as a principal residence?

It is clear that a person can be an occupant for purposes of Section 121 without holding title. In the cited IRS ruling on the issue, since the beneficiary of the trust was treated as the owner for tax purposes, the next question was, does she satisfy the "use" requirement? The issue of use can only be a factual question, although the legal right to use may be a factor, especially with the kind of plan we are discussing. In the typical case, we assume that the individual or couple who transfers their home reserving powers of appointment does, in fact, use the property as their principal residence. In such cases, however, I recommend supporting the factual use with the legal right to use.

A simple way to establish the legal right to such use and occupancy would be to have the holder of the power enter into a lease with the transferees. The lease would be given by the transferees as lessors, since they are the legal owners of the property. The transferees' interest is vested subject to divestment only by an exercise of the power. Restatement of Property, Second, §11.2, comment c.

Duration of the Lease

The lease should not be for the transferor's life, as this is not a life estate, nor do we want it interpreted as such. The lease may be for, say, a five-year period, with one or two options to renew, depending on the age and life expectancy of the lessor. It may be for a market rate or rent, or for an amount calculated to cover all maintenance and expenses. It is interesting to note that there will be no income tax consequences to the lessor or the lessee, since the lessee is the owner for tax purposes. Nevertheless, for purposes of the capital gains exclusion, the existence of a written lease gives the transferor (holder of the power) the legal right to use and occupancy. If the transferor is institutionalized, he must occupy the property for only one year out of the five-year period preceding the sale. IRC §121(b)(9).

Accordingly, if the transferor with a reserved special power is treated as the owner of the property for tax purposes, and if he has the right to use and does in fact use the property for the requisite time period, there should be no question that he will qualify for the Section 121 capital gains exclusion.

A Caveat

In the event of a sale, note that it is the transferee who will execute the deed over to the third-party purchaser, since, as explained, the transferee is the legal title holder. It is the transferor, however, as the tax owner and occupant of the property, who will be entitled to the capital gains exclusion and who will be taxed on any gain in excess of the applicable exclusion. There is one caveat, however: if the transferor releases the power before the sale, the gift will be complete, he will not be considered the owner at the time of the sale, and the exclusion will be lost. For this reason, it is essential that the transferor does not release the power of appointment until just after the sale takes place. This should be easy to arrange with the buyer's attorney, since it is merely a matter of the order of delivery and recording of the documents. To repeat, if this is not properly done, the gain will be taxed to the transferee and the exclusion will be lost. Note also that the release of the power is not a transfer for Medicaid purposes, since the transfer has already been made. State Medicaid Manual, Transmittal No. 64, (November, 1994) HCFA Pub 45.3, 3258.4.

After the disqualification period and while the transferor lives in the home, the home will not be a countable asset, even though the transferor has retained the power to decide who will ultimately own the property. This is because title to the home has been transferred for Medicaid purposes. Possession of the special power of appointment is not a countable asset because the power of appointment itself is neither property nor a property right; it is merely a "personal privilege." Restatement of Property, Second, 7. For this reason, it also escapes the reach of estate recovery, since the deceased has no "legal interest" at the time of his death, and therefore there is nothing for the state to recover, and this includes the concept of expanded estate. 42 U.S.C. §1396p(b)(4)(B).

As an important drafting note, a deed of the home with reserved testamentary powers should indicate that if no exercise of the power is recorded within 30 or 60 days after the powerholder's death, it will be conclusively presumed to be a default of the power. Otherwise the powerholder's estate will have to be probated to establish the exercise or non-exercise of the power. Furthermore, as to the lifetime power, language should be included that will allow the power to be exercised or released by the grantor's attorney-in-fact acting under a durable power of attorney. This will allow for flexibility in the event the power has to be exercised or released and the powerholder is unable to do so.

Conclusion

A transfer of the home with reserved special powers of appointment can provide the best of all possible worlds. It can completely protect the home from the reach of Medicaid after the applicable waiting period while allowing the powerholder to retain control of the property and preserve all desirable tax benefits with no exposure to estate recovery.

Alexander A. Bove, Jr., is a Boston attorney specializing in trusts and estates and an adjunct professor of law at Boston University Law School's Graduate Tax Program. Parts of this article were excerpted from his recent book The Lawyers Medicaid Practice Manual (Sacker Publications, Boston).

Deed Of Real Estate

Reserved Lifetime And Testamentary Special Power Of Appointment

The Grantor reserves the power to appoint, in whole or in part, the property conveyed hereunder to or for the benefit of anyone or more of the Grantor's issue in such proportions, outright or upon such trusts, terms and conditions as the Grantor may specify by a writing executed and acknowledged during his lifetime and recorded in the ______County Registry of Deeds within sixty (60) days of the date of such exercise, or by his last Will or Codicil making specific reference hereto. In the latter case, failure to record notice of any such exercise of this power in the ______County Registry of Deeds within sixty (60) days of the Grantor's death shall be conclusively treated as a default in the exercise of the power. A release of the power reserved hereunder, in whole or in part, shall be effective when recorded with the ______County Registry of Deeds. Any exercise or release of the foregoing powers may be made by the Grantor's attorney in fact acting under a durable power of attorney.