This is the first of three blogs (today, tomorrow and Monday) on this important topic. I hope you find it helpful.
Outright gifts have the advantages of being simple to do with minimal costs. Many financial institutions have their own documents for changing ownership of assets so there are typically no out-of-pocket costs for the transferor.
So, why complicate things with a trust? 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 are forfeited by outright gifting. These benefits are what give value to using irrevocable trusts in Medicaid planning.
We will briefly discuss each of these potential benefits. Each of these potential benefits depends on the specific language selected in the design and drafting the trust. None of them is automatic or inherent in every trust. Thoughtful planning and careful drafting is necessary to take advantage of the benefits available, thus it is important to understand how and why each benefit comes about.
Asset Protection from Future Creditors of Beneficiaries
A central benefit of gifting in trust is to protect the gifted assets from the creditors and predators of the beneficiaries. This is accomplished by means of special provisions in the trust that make trust assets unavailable for attachment, foreclosure, garnishment, or a laundry list of undesirable actions by the creditors of the beneficiaries.
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 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. A trust can preserve this benefit, outright gifting cannot. Our senior population often has owned their home since the late 1940s, 1950s or 1960s, so a huge amount of appreciation in value has occurred since then.
Preservation of Step-Up of Basis
When an appreciated asset is included in a decedent’s taxable estate for federal estate tax purposes, 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 donees with the donor’s adjusted cost basis, rather than the date of gift value of the assets. However, a provision in an irrevocable trust that pulls the property back into the taxable estate of the Trustmaker upon their death can preserve step-up of basis for benefit of the donee. 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 to design into the trust, without any actual tax liability. A Limited Power of Appointment retained by the Trustmaker can accomplish this. Other provisions can also cause taxable estate inclusion.
Part II (tomorrow) will discuss in detail each of these key benefits.