Using an Irrevocable Trust to Protect Your Home
Your most valuable property may be your home, which is true for many people. You likely want your children to inherit that value when you pass away.
However, you may also have concerns about planning for the future, especially if your health declines and you need expensive long-term care. You may be aware that Medicaid can pay for these services. However, Medicaid rules say you can own no more than around $2,000 in assets to be eligible – now what?
Medicaid Planning Using an Irrevocable Trust
One solution is to take your home out of your name while reserving your right to live in it. This is possible with a carefully drafted irrevocable trust.
Putting the house in the ownership of a trust could prevent Medicaid penalties and ensure reimbursement of health expenses. (Note that each state’s rules can vary.) It all depends on whether your health continues to keep you out of long-term care for the next five consecutive years.
An irrevocable trust has numerous other advantages, one of which is to avoid probate proceedings. Trusts are private agreements that usually require no court supervision. So, signing away valuable property can feel like a major step, but it keeps your living situation unchanged and can pay off in the long run.
Avoiding Capital Gains Taxes
But suppose you later decide to sell the house and move into a smaller place. That could pose a capital-gains tax problem. If the trust hasn’t been carefully drafted, and it (not you) sells the home, the personal residence exemption would be lost. Capital gains tax could be prohibitive if the house has appreciated in value since the date of purchase.
A similar problem arises when it comes time for your children to inherit. If the trust is not carefully drafted to cover this eventuality, your heirs will lose the basis-adjustment tax break, which could cost them dearly. The basis adjustment allows the inherited value of the home, for capital-gains purposes, to be calculated not from the date you originally purchased the home but from the date your heirs inherit the property.
For example, imagine you paid $100,000 for your house in 1980, and you kept it in good condition; when you pass away, the house is worth $300,000. Now suppose the home is titled in the trust name, but the trust wasn’t written carefully to preserve the basis adjustment that would otherwise be allowed for inherited property. If the children sell the home for $350,000 in those circumstances, they would have made a taxable profit of around $250,000.
With the basis adjustment, however, profit would be calculated from the $300,000 mark as of the date of inheritance. This would leave your children with a tax bill on the $50,000 profit, not $250,000. This tax advantage comes from “stepping up” the taxable basis to the market price at the time of inheritance. As a result, your family receives more value by having to pay less taxes.
Protecting Your Assets for Heirs with an Irrevocable Trust
First, the irrevocable trust takes the home out of your name and, instead, titles it to the trust. Medicaid rules view the owner of the property as the trust, not you, and that’s why you want to reduce your assets and qualify for Medicaid assistance.
Next, to preserve the personal residence capital-gains exemption, an irrevocable trust creates what’s known as grantor trust tax rules. Current tax rules allow property owned by this kind of trust to remain part of your estate for tax purposes and exempt from capital gains up to specified value limits, depending on your state and whether you file single or jointly as a married couple.
Even though the trust has ownership, you are still allowed to take the personal residence exemption. For capital gains, the IRS disregards the trust. However, as of 2023, assets transferred to an irrevocable trust before your death that are not subject to estate tax will not receive a step-up in basis.
To minimize your heirs’ exposure to capital gains tax in the future, the trust also provides a limited testamentary power of appointment. The appointment power permits you to designate someone with the authority to disburse your assets to chosen beneficiaries, provided those beneficiaries are limited to family or charities.
The limited power of appointment allows your assets to pass down to beneficiaries while preserving eligibility for both the tax basis adjustment and Medicaid.
The right estate planning strategies neatly solve Medicaid planning and tax issues by:
Transferring the house title to the irrevocable trust while retaining your right to live in it, avoiding Medicaid penalties or reimbursement problems after five years
Creating grantor trust status to preserve the residence exemption, avoiding capital gains tax on the sale during your lifetime
On your death, the adjusted-basis tax break is preserved by designating a person or entity to administer the assets in the trust
Trusts are carefully drafted to comply with current rules regarding ownership and taxes to prepare for Medicaid eligibility and protect your assets for your family.
