by Anita Schnee, Attorney at Law
Here’s a puzzle we solve for our clients all the time.
Suppose your most valuable property is your home, as is true for many people. You want your children to inherit that value when you pass. However, you are also concerned about planning for the future, in case your health declines and you might need expensive long-term care. You have heard that Medicaid can pay for that, but the rules say you can own no more than around $2,000.00 to be eligible.
One solution is to take that big asset, your home, out of your name, while reserving your right to live in it for as long as you want to. This can be done with a carefully drafted irrevocable trust. Putting the home in that kind of trust could forestall Medicaid penalties or reimbursement, depending on current rules, provided your health stays good enough to keep you out of care for five years subsequently.
There are numerous other advantages to that kind of trust, 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 big step, but it keeps your living situation unchanged, and it can really pay off in the long run.
But suppose, later, you decide to sell the house and move into a smaller place. That could pose capital-gains problems. If the trust hasn’t been carefully drafted, and it (not you) sells the home, the residence exemption would be lost. Capital gains tax could be prohibitive if the home appreciated in value since you purchased it.
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. That, too, 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 it.
For example, suppose you paid $100,000 for your house in 1980 and you kept it up in good condition. On your passing, the house has become 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 date of inheritance. This would leave your children with a tax bill on $50,000 profit, not $250,000. This tax advantage is commonly known as the “step up in basis.” Because the value of the house appreciated, the taxable basis is “stepped up” to market price at time of inheritance. More value, less taxes. It’s an upside-down world, but it’s better that way than the other.
Here is how our trusts solve all three problems, reliably and efficiently.
First, as noted, the irrevocable trust takes the home out of your name and, instead, titles it in the trust name. So, as far as the Medicaid rules are concerned, the trust owns the property, not you, and that’s just what you want in that context. You must own very little to qualify for Medicaid assistance.
Next, to preserve the personal-residence capital-gains exemption, our irrevocable trusts create what’s known as “grantor trust” status. Current tax rules view property owned by this kind of trust as still part of your estate. So, if you want the grantor trust to sell the house, capital gains tax will still be exempted up to certain value limits, depending on whether you file singly or as a married couple.
Our trusts preserve this advantage even though it’s the trust that is the actual titleholder and seller. No matter. Grantor trust status means that you would still be entitled to take the personal-residence exemption. For capital-gains purposes, the IRS essentially disregards the trust title and calls the property yours for the residence exemption.
Then, to minimize your heirs’ exposure to capital gains tax in the future, our trusts also provide what’s called a “limited testamentary power of appointment.” Both tax strategies discussed here – the grantor trust and the power of appointment – are like strings that pull property from the trust back into your personal estate for tax purposes. The appointment power permits you to apportion your property among your beneficiaries by a last will if you so choose, provided those beneficiaries are limited to family or charities. (Without that limitation, you’d be solving a tax problem but backing into another problem with Medicaid eligibility.)
So, again, the limited power of appointment transforms the property from trust-titled property into what’s nominally yours for inheritance purposes, to bequeath in a final testament and, crucially, to preserve eligibility for both the basis adjustment and for Medicaid.
In sum, then, these three planning strategies neatly solve Medicaid and tax issues like this:
1. Transferring the house title to the irrevocable trust, while retaining your right to live in it, avoids Medicaid penalties or reimbursement problems after five years; and
2. Creating grantor trust status, to preserve the residence exemption, avoids capital gains taxation on sale during your lifetime; and
3. On your death, the adjusted-basis tax break is preserved by way of the testamentary power of appointment.
Our trusts are carefully drafted to comply with current rules on all three issues in all three contexts, and the overall plan dovetails beautifully.
But what if somebody other than us drafted your irrevocable trust? Bring it to us and let us look it over. If we find that it isn’t Medicaid-qualified, or it lacks provisions for grantor trust or power of appointment, don’t worry. “Irrevocable” doesn’t necessarily mean “can’t ever be changed.” Trusts that fail to account for various of these complicated contingencies are hardly unheard-of. Therefore, Arkansas legislation permits modification of trusts for tax reasons, even if the trusts are nominally irrevocable. Court proceedings would be required, but we know how to take care of all that efficiently. Call us.
