Reverse mortgages and irrevocable trusts

A reverse mortgage allows you to access some of the equity in your home while you still live in the home. If you place this home in an irrevocable trust, you may be able to avoid estate taxes when you die and more easily qualify for Medicaid benefits if you ever need to go to a nursing home. Let’s see how reverse mortgages and irrevocable trusts work and what happens when the two are combined.

Key points to remember

  • Reverse mortgages allow people aged 62 and over to tap into some of the equity in their home without selling the home.
  • Irrevocable trusts are a way to protect assets, including a home, from estate taxes. They can also make it easier to qualify for Medicaid benefits.
  • Reverse mortgages and irrevocable trusts can be expensive and have other disadvantages.
  • A home with a reverse mortgage can be held in an irrevocable trust, although this is probably not beneficial for most people.

How a Reverse Mortgage Works

A reverse mortgage allows a homeowner to extract equity from their home in a variety of ways, including a lump sum, monthly income, or a line of credit to draw on as needed. The loan must be repaid after the borrower dies, moves or sells the house.

The most common type of reverse mortgage is the home equity conversion mortgage (HECM), where the borrower and any co-borrowers must be at least 62 years old. The loan is insured by the Federal Housing Administration (FHA) to protect the lender. Young spouses can be enrolled on the loan as an eligible non-borrowing spouse, which entitles them to stay in the home after their spouse dies or leaves (such as in a nursing home), if they meet certain other conditions.

HECMs are issued only by FHA-approved lenders. The maximum loan amount is $970,800. Some lenders also offer proprietary reverse mortgages, which are not government insured but may have higher loan limits.

How an Irrevocable Trust Works

Trusts can be revocable or irrevocable. With the former, you can change the terms at any time. With the latter, the terms are much more difficult to change.

Both types of trusts can give you more control than a last will over how your assets are managed after you die (or sometimes during your lifetime). Both can also allow assets, such as your home, to bypass the often slow and costly probate process. In general, trusts are harder to successfully challenge for disappointed heirs.

An irrevocable trust, as its name suggests, locks in the decisions you make when you first create it. So, for example, changing beneficiaries can be very difficult. The assets you place there become the property of the trust and are beyond your control. This means that they are not taken into account in determining your estate tax liability or your eligibility for Medicaid (if you meet other rules, as described below) and are protected from creditors. .

Irrevocable trusts are generally more expensive to establish and maintain than revocable trusts. They can take various forms depending on what the settlor (the person setting up the trust) wants to accomplish.

Use an Irrevocable Trust to Avoid Inheritance Tax

Because they remove assets from the settlor’s estate, irrevocable trusts can be used to avoid (or reduce) estate taxes. However, this will only benefit people with a fairly large wealth. In 2022, the first $12,060,000 of assets are exempt from federal estate tax.

Seventeen states plus the District of Columbia also impose estate taxes, and they also exempt assets up to a certain level, all exempting at least $2-5 million. According to the Center on Budget and Policy Priorities, less than 3% of estates on average owe state property taxes.

$2-5 million

The value of assets that 17 states plus the District of Columbia exempt from their state property taxes.

Using an Irrevocable Trust to Qualify for Medicaid

Medicaid is a joint state and federal program which provides health insurance coverage to many low-income Americans, as well as those who are elderly, blind, or disabled. Program rules may vary from state to state.

People who might never have qualified for Medicaid coverage when they were younger often turn to it to pay for nursing home care or other long-term care services later in life. Medicare, the federal health insurance program for Americans age 65 and older, provides such coverage only in very limited circumstances.

To be eligible for Medicaid coverage, a person must be eligible based on medical need and also meet certain income and asset requirements. One of these assets is the equity in their home, although it is exempt up to a certain limit. With the exception of California, the limit in most states today for single people applying for Medicaid is $636,000 or $955,000, according to the American Council on Aging. California does not set a limit.

If the Medicaid applicant is married, there is no home equity limit as long as the other spouse lives in the home. In addition to any home equity that exceeds the exemption limit, accounting assets can include bank accounts, investments, retirement accounts, and second homes.

Spending reduction and look-back period

People whose assets exceed the limits often use a tactic called “spending”, in which they spend assets in order to go under the limits. Expenditures are subject to a look-back period (five years in most states) during which the Medicaid applicant cannot simply have disposed of assets or sold them for less than fair market value, such as selling a house with a strong discount to another family member.

The list of expensive items allowed during the lookback period is relatively limited and includes items such as home modifications, car repairs and medical devices that are not covered by insurance. The applicant can also pay out of pocket for nursing home care until they spend enough to become eligible for Medicaid coverage.

Another way to reduce accounting assets is to place them in an irrevocable trust. However, the trust must be established before the start of the look-back period to qualify.

There are also several exceptions that allow a Medicaid applicant to transfer their home to a relative during the lookback period. They include the child caregiver exception, which allows the home to be transferred to a child who has been the claimant’s primary caregiver for at least two years and who has also lived in the home. Another is the sibling exception, for siblings who co-own the home and have lived there for at least a year.

When homes with reverse mortgages are held in irrevocable trusts

Irrevocable trusts and reverse mortgages serve different needs and generally appeal to different types of people. The former are of the greatest use to people with significant assets that they wish to keep and pass on to their heirs. These tend to benefit people who may not have any assets other than their home, which may not be of huge value. The median loan amount for a HECM in 2018 was around $134,000.

Given the relatively large exemptions on home equity for Medicaid, as well as equally large exemptions for federal and state estate taxes, few reverse mortgage borrowers are likely to find an irrevocable trust to be of much benefit. . Rather than a trust, a homeowner whose net worth exceeds the limits could potentially use a reverse mortgage to reduce that net worth, but would need to consider the cost of the reverse mortgage as well as the effect of adding of the mortgage proceeds to its other assets.

Still, it is possible to put a house with a reverse mortgage into an irrevocable trust, and some beneficiaries of irrevocable trusts will eventually inherit it. In such a case, the beneficiary will still have to pay off the reverse mortgage, either by selling the house or by buying it themselves. If they are lucky, the trust will provide them with the funds to do so.

How much does an irrevocable trust cost?

The cost of establishing an irrevocable trust will vary depending on the type, complexity of the estate, the US state in which it is created, and other factors. In most cases, it will be at least $3,000. A New York law firm pegged the average price at $6,000. In addition, there will be ongoing administrative costs that will likely run into the hundreds or thousands of dollars per year.

What if you want to modify an irrevocable trust?

Irrevocable trusts are difficult, but not impossible, to change. A technique that has become more common in recent years is known as “decanting”. In states where it is allowed, the trustee “transfers” the assets of the existing irrevocable trust into a new one with different terms.

Are reverse mortgage payments considered taxable income?

No. The Internal Revenue Service (IRS) considers the money a homeowner receives from a reverse mortgage to be loan proceeds rather than income, and loan proceeds are not taxable.

The essential

Reverse mortgages and irrevocable trusts can be useful tools for financial and estate planning in some cases. However, they are both complicated and potentially expensive and are not suitable for everyone.

If you’re interested in an irrevocable trust or reverse mortgage, you’ll want to consult with a knowledgeable expert, such as an estate planning attorney, accountant, or financial planner, before proceeding. In the case of HECM reverse mortgages, the government also requires that you meet with a licensed housing counselor.

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