The Listen to Lawrence Letter: Does a beneficiary receive a step-up in basis on assets in an Irrevocable Medicaid Trust?

October 12, 2021
Dear Clients and Friends:
The phrase “step-up in tax basis” is one you might have heard before but maybe you were not exactly sure of what it is and how it works especially when it comes to assets that need to be distributed and are held in an Irrevocable Medicaid Trust.
I’m going to give you a very clear and concise answer so you’ll never be in doubt again. Plus, as a bonus, you’ll understand why this type of trust works so well since it protects assets AND preserves the step-up in tax basis vs. assets that are transferred outright and have a carry-over basis. Confusing? Just read on…
Do beneficiaries of an irrevocable Medicaid trust receive a step-up in basis of the assets held in the trust when the assets are distributed to the beneficiaries?
Our parents set up and funded an irrevocable trust in order to be able to qualify for Medicaid in the event they needed to go into a nursing home. Neither parent was ever placed in a nursing home. My mother received Community Medicaid for about a year before she passed away this past April. Dad passed away several years ago. Three of my siblings are trustees and all five of us are beneficiaries. We would like to terminate the trust and distribute the assets to the beneficiaries. Each of us would take a like-kind transfer of the assets held by the trust. The trust assets are held in a stock mutual fund.
Thank you for any guidance you can provide.
Let me put this question into context. If you bought a stock for $1 and sold it for $10, you would have a capital gain of $9 dollars. The $1 is considered your basis and any amount you receive upon sale above your basis is taxed at the relevant capital gain rate. If you died owning the stock at a time when it was worth $10, whoever inherits your stock receives a new (STEPPED-UP) basis equal to its value at the date of your death. If you gave the same stock to your children, outright, prior to your death, then they would receive the stock with your $1 basis and the step-up upon your death would be lost. This is called CARRY OVER tax basis.
So the question then becomes, can you still get a stepped-up basis upon your death in a case where you placed your assets in an irrevocable Medicaid trust before you died?
The answer is YES! In fact, it is one of the most important reasons why these trusts are so popular.  Not only can you protect your assets from Medicaid, but you preserve your step-up in tax basis. Note that if you simply transferred your assets to your children, they would get your carry-over tax basis.
The law says that if you put your assets in an irrevocable trust, but retain enough control over the trust, the beneficiaries will still enjoy the step-up in tax basis. What is sufficient control? The two most important categories are (1) the retained right to income, possession, or enjoyment of a trust asset and (2) the retained right to change who will enjoy a trust asset.  If you retain the income from the trust, or the right to possess a house, for instance, there will be a full step-up on those assets subject to this retained power. Likewise, if you retain a power of appointment, the power to change trust beneficiaries, then again you will receive the full step-up. All of my Medicaid trusts contain one or more of these retained powers to get the step-up in basis.
However, in your parents’ case, there were two people (this is common) who set up the trust. Therefore, the trust assets would receive a full step up on 50% of the trust assets upon your father’s death and a full step up on your mother’s 50% upon her death. It is possible that there will still be some capital gains tax to pay on your father’s 50% if his half appreciated between his death and your mother’s 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.
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Stay safe!
Until next time,
peace, health and happiness,
Lawrence Eric Davidow