Even though Federal Medicaid law imposes a 5-year look-back period for all asset transfers there are situations in which people elect to transfer assets as part of their Medicaid planning strategy. In such situations, they will need to determine whether to transfer the asset outright or use an irrevocable trust. Outright gifts have the advantage of being simple to do with minimal cost involved.
So, why complicate things with a trust? Why not just keep the planning as simple and inexpensive as possible? The short answer is that gift transaction costs are only part of what needs to be considered.
Many important benefits that can result from gifting in trust; such as providing creditor protection for the assets, are forfeited by an outright gift. However, two of the more significant benefits of using an irrevocable trust are tax related. The potential tax benefits depend on the design and drafting of the trust. None of the potential benefits are automatic or inherent in every trust. Thoughtful planning and careful drafting are necessary in order to take advantage of these benefits. Please keep in mind that this is just an introduction to the topic and you should consult an Elder Law attorney before making any decisions.
Any time you have a discussion regarding “gifting” it is necessary to use the terms “donor” (the person making the gift) and “donee” (the person receiving the gift). Many times clients find references to donor and donee confusing. So, for purposes of illustration, I will assume the “parent” is transferring the asset (“donor”) and the “child” is receiving the asset (the “donee”) either outright or as a beneficiary of the irrevocable trust.
Preservation of Section 121 Exclusion of Capital Gain on Sale of Principal Residence
Section 121 of the Internal Revenue Code creates an exclusion from capital gains tax of up to $250,000 of capital gain in the taxpayer’s principal residence when it is sold if the taxpayer owned and lived in it at least two of the past five years before the sale (only one of the past five years if the homeowner had to move to a nursing home). If there are two qualifying co-owners, they can each exclude $250,000 of gain upon sale in such circumstances. It is possible to preserve this capital gain exclusion benefit with a properly structured trust. On the other hand, a residence gifted outright to someone and then sold by the successor would need to qualify for the Section 121 exclusion based on the ownership of the donee (child) to avoid capital gain in excess of the adjusted cost basis of the donor (parent).
Preservation of Step-Up of Basis
When an appreciated asset is included in a decedent’s estate, it receives step-up (or down) of basis to the date of death value under Section 1014 of the Tax Code. Normally, gifted assets pass to the donee (child) with “pass through basis”. That is, the donee (child) receives the asset with the donor’s (parent’s) adjusted cost basis, rather than the date of gift value of the assets. If, however, something pulls the assets back into the taxable estate of the donor (parent) upon the donor’s (parent’s) death, the donee (child) will own the asset at that point with the date of death value as his or her basis, rather than the donor’s (parent’s) original adjusted cost basis.
For highly appreciated assets, obtaining step-up of basis can be a huge benefit for minimizing or eliminating capital gains tax when the donee (child) later sells the assets. This benefit of step-up in basis can easily be forfeited by outright gifting. In some instances, it is possible to structure an irrevocable trust such that it pulls the property back into the taxable estate of the settlor (parent) upon the death of the settlor (parent) and preserve the step-up of basis benefit for the donee (child). With the amount of assets that can pass free of federal estate tax being well beyond the value of most Medicaid planning clients’ estates, estate inclusion and step-up of basis is generally a great benefit.
Conclusion
The above discussion demonstrates that the use of an irrevocable trust in Medicaid planning, as in other fields of estate planning, can provide an opportunity to create benefits beyond simply transferring assets. If care is taken in the design and structure, an irrevocable trust can provide tax benefits that greatly enhance the value of the clients’ Medicaid planning beyond what can be accomplished through outright gifting.
To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this article was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.