Transferring Real Property into an Irrevocable Trust
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As our longevity increases, elder law practitioners are tasked with devising and implementing planning that allows our clients to live life to the fullest, have the means to afford health care when needed, and without impoverishing themselves or their spouses. This article discusses the specific planning tool of the irrevocable trust and its use in connection with the transfer of real property.
Why do Medicaid planners use irrevocable trusts as opposed to revocable trusts? It comes down to how Medicaid treats the ownership of the property after the transfer into the trust. A revocable trust is one that may be changed or rescinded by the person who created it. Medicaid considers the principal of such trusts (i.e., the funds or property that make up the trust) to be assets that are countable in determining Medicaid eligibility. Therefore, revocable trusts are not useful in Medicaid planning. The objective of Medicaid planning is to shelter your client’s assets so that the Medicaid program pays for the cost of their long-term care. That means that clients must divest themselves of ownership and control of their property. This is where the irrevocable trust becomes an effective planning tool.
An irrevocable trust is a legal entity under which a person or persons—trustee(s)—hold legal title to the assets contained in the trust for the benefit of others—the beneficiaries. An irrevocable trust cannot be changed after it has been created, except under very limited circumstances governed by the EPTL (Estate and Powers and Trusts Law) §7-1.9. Generally speaking, to protect the property from being considered available as a resource by Medicaid, the trust’s terms state that the Settlor cannot have any access to or be paid the trust principal. In the case of real estate’s inclusion in an irrevocable trust, if the trustees are given the power to sell the property, then the proceeds must be placed back into the trust, or distributed to the beneficiaries, but never given to the Settlor.
Why not simply transfer the property outright to your intended beneficiaries? That strategy may be appropriate in very narrow circumstances. Overall, however, an irrevocable trust offers certain tax advantages over a direct gift—specifically, the avoidance of a capital gains, preservation of all senior- related and veterans exemptions, and preservation of the capital gains tax exclusion on the sale of a principal residence.
With regard to the capital gains taxes, if the trust is structured as a grantor-type trust, with the grantor retaining a life estate in the property, the appreciated property transferred into the trust receives a step-up in basis upon the death of the grantor. Moreover, the Grantor also retains all available veterans and senior exemptions. I recommend that the deed also contain the reservation of a life estate language and tax exemptions. A sample deed is linked to here to illustrate the language. If the real estate was gifted outright to the beneficiaries, they would retain the same basis as the donor had, and in most cases, would incur a substantial capital gains tax that could have been avoided. Internal Revenue Code (IRC) §121 provides that a single taxpayer may exclude up to $250,000.00, or in the case of a married couple, up to $500,000.00 of capital gains from the sale of a personal residence, provided that the taxpayer resided in the home as his or her personal residence for at least two of the preceding five years. This exclusion is lost for the Grantor when an outright gift is made.
Lastly, an irrevocable trust can be drafted to preserve the capital gains tax exclusion on the sale of the principal residence. Specifically, if a trust is treated as a grantor trust as to its income and principal under IRC §671 through 679, the Grantor will be treated as the continued owner of the residence for purposes of the capital gains tax exclusion. The most common power included in the irrevocable trust that contains real property that satisfies the aforementioned sections of the IRC is the power of the Grantor to reacquire the trust corpus by substituting other property of an equivalent value. The loss of this exclusion with an outright gift could prove disastrous. Remember that funding an irrevocable trust triggers a five- (5) year look-back penalty when applying for institutional Medicaid, which is why a real estate practitioner’s understanding of irrevocable trusts is so important.
Linda Redlisky, Esq. is a partner at Rafferty & Redlisky, LLP in Pelham, New York. She concentrates in elder law and guardianship matters. She can be reached at email@example.com