Question: I am considering creating an Irrevocable Trust to protect my house and other assets, but I am concerned about creating a situation where my children will have to pay Capital Gains tax.
Answer: An “Irrevocable Trust’ can offer the creator, often referred to as the “grantor,” lifetime control over his or her assets, without creating a capital gains issue so long as the trust is a Grantor Trust for income tax purposes. Certain provisions within the trust create grantor trust status allowing the grantor to maintain his or her tax exclusion if the house is sold during their lifetime and also providing the beneficiaries with a fully stepped up basis and therefore no capital gains tax due at the time of sale.
After the trust is established, totally funded, and 60 months passes, assuming all other eligibility requirements are met, the grantor will qualify for Chronic Medicaid benefits. None of the trust assets will be included as assets in the grantor’s name for the purpose of the Medicaid application, because they were transferred prior to the five-year look-back. The grantor will qualify for Medicaid benefits with generally his or her personal property, a prepaid funeral plan, IRA and qualified accounts in any amount, so long as they are in pay out status and $14,550.00, or less, of cash assets (2014 figures).
From an income tax standpoint, so long as the grantor has retained the right to the taxable income, and has retained a limited power of appointment over the final distributions of the trust, the trust is considered a “grantor trust. Grantor trusts do not pay any income taxes. Instead, the income flows directly out of the trusts to the grantor, to be placed on their personal income tax returns. For many, the end result is a lower total tax, in that the trust tax rates for individuals are much lower than those for non-grantor trusts.
From a gift tax standpoint, again, since the grantor retained all taxable income and a limited power of appointment over the final distributions of the trust, these provisions prevent the funding of the trust from being treated as a “completed gift.” The end result is that without a taxable gift, no gift tax will be due, nor the requirement that a gift tax return be completed and filed.
Finally, from an estate tax viewpoint, because the transaction is not a completed gift, the trust assets will be included in the grantor’s gross estate. The end result is that certain trust assets will receive an automatic step-up in basis. For example, if a grantor paid $30,000.00 for a house, and made lifetime improvements of $20,000.00, his or her cost basis is $50,000.00. At the time of the grantor’s death, if the house was worth $350,000.00, the beneficiaries would receive a tax basis of $350,000.00. Thus, if they later sold it for $350,000.00, or less, they would not owe any capital gains tax. The sale would be tax-free. The present law states that each trust asset will receive that same benefit when the grantor passes away and the assets pass through the trust. In sum, Irrevocable Grantor Trusts can offer excellent asset protection with little to no Capital Gains tax implication.