Dear Clients and Friends,
In my previous LISTEN TO LAWRENCE LETTER, I asserted that for all of you who placed your homes into an irrevocable trust, that your beneficiaries will receive a step-up in basis, wiping out your capital gains at death. THIS ASSERTION REMAINS TRUE FOR ALL OF MY IRREVOCABLE MEDICAID TRUSTS. However, for this assertion, I was applauded by my clients and rightly challenged by a tax attorney and a CPA.
THE ATTORNEY’S CHALLENGE:
Hi. The example below has an error. There is no step-up in tax basis for assets in an irrevocable trust. Happy to discuss by phone. I suggest you resend your email with that correction.
THE CPA’S CHALLENGE:
Am I correct that this would only be true if Mom was given a life estate in the house when the trust was set up? I know some trusts were set up so that Mom would have a set period of residency after which she would have to start paying rent or move. If she outlived the period, then the house would be out of her estate but before the period, it wouldn’t.
There are many different types of trusts, created for many reasons. The type of irrevocable trust I was referring to in my example was an IRREVOCABLE MEDICAID TRUST. In these trusts, the Grantor retains many rights, including the right to reside in the property for life and the right to change the ultimate beneficiaries of the trust. These retained rights cause the property to be included in the estate for estate tax purposes upon death while protecting the property during life from Medicaid after the 5-year look-back. If a trust asset is includable in the estate for estate tax purposes then the step-up in tax basis is achieved. Note that we do not care about the estate tax because people concerned with protecting assets from Medicaid are not wealthy people, their assets will be under the state and federal estate tax exemptions (New York $5.93 million, Federal $11.7 million).
However, the tax attorney was correct when talking about placing an asset, like a house, in an irrevocable trust, where the goal is to reduce the estate of the Grantor because their wealth exceeds the state and federal exemptions. In this context, the goal is to remove the assets from the estate. One way to accomplish this is to gift assets to an irrevocable trust with NO RETAINED RIGHTS so that the assets will not be included in the taxable estate. If the assets are not includable in the estate, then there is no step-up in tax basis. We will sometimes do this for our very affluent clients where the capital gains tax paid (because of the loss of the step-up in basis) is less than the estate tax rate.
The CPA was also right. With our Medicaid trust, the Grantor is reserving the right to live there for their entire life (akin to a life estate). This gets the step-up. However, for our very affluent clients, we sometimes create what is called a QUALIFIED PERSONAL RESIDENCE TRUST (QPRT) where the Grantor transfers their house to an irrevocable trust but only reserves the right to live there for a set period of time. If the Grantor outlives the term, then the house will be out of the taxable estate at a discounted cost, subject to the loss of the step-up in tax basis.
The theory here is that if you gift a $1 million dollar house to a trust but keep the right to live in the house for 15 years, then the gift is really $1 million less what you kept. The IRS has a table that will tell us what the value is for you to live there for 15 years. Hypothetically, let’s say that the retained right is worth $500,000. Therefore your taxable gift would have not been $1 million but rather $500,000 ($1 million less the retained $500,000). If you outlive the term, then the $500,000 retained value disappears, never to be taxed. There are other benefits to this type of planning, and yes, often our clients rent the house from the trust at the end of the retained term. Here again though, if the grantor outlives the term, they will achieve estate tax savings but lose the step-up in basis causing the trust beneficiaries to pay high capital gains, usually a worthy trade-off.
I want to thank this tax attorney and CPA (whom I both called personally) for advancing this discussion. We all now agree that all of you who created an IRREVOCABLE MEDICAID TRUST will receive a full step-up in tax basis on all trust assets upon your death.
I hope this helps! Please forward this information to your friends and relatives to share these informative answers to some very commonly asked questions.
And, if anyone you know would like to receive this
LISTEN TO LAWRENCE LETTER, just have them email me at email@example.com and I’ll add them to the list!
As always, please send me your questions. If you are thinking about it, others are probably too, so my answers will no doubt help you and many others.
Let’s stay connected.
LISTEN TO LAWRENCE