Many people hear the words "Irrevocable Trust" and think that
the irrevocable nature of the instrument requires inflexibility and rigidity,
or that they will lose control over their assets. This is a common myth.
An irrevocable trust may enable an individual to retain a significant
degree of control over assets during life, while providing for protection
from creditors and reducing tax liability for the person's heirs following
death. Putting assets into an irrevocable trust also may help to reduce
the risk that a child's creditor or ex-wife will take the assets while
the parent is alive.
One very big concern that has been growing recently is the possibility
that a person's hard-earned assets will have to be spent down to cover
the costs of necessary long-term medical care, leaving nothing to transfer
to the healthy spouse, children, or other loved ones. Long-term care costs
have been rising, and the law allows Medicaid to look back up to five
years to determine if any assets have already been transferred. For that
reason, it is important to come up with a strategy to protect these assets
while a person is healthy, before the need for long-term medical care
arises. The longer that a person waits to protect assets, the more likely
it is that the assets will not be protected. One way for parents to avoid
having their remaining assets used to pay for long-term medical care is
to place the assets in an irrevocable trust as part of a comprehensive
Consider a hypothetical married 70-year-old couple in good health with
two children. They own a home worth approximately $500,000 and have approximately
$300,000 in other assets. The couple wants to protect their assets from
being taken to pay creditors, including long-term care providers, and
to avoid the costs associated with probate. One solution for this couple
may be to transfer some or all of their assets to an irrevocable trust.
The husband and wife would be the grantors to the trust and would choose
an independent trustee to manage the trust during their respective lifespans.
The trustee, would have the ability to pay necessary expenses from the
trust assets. Using an independent trustee can give a person a much greater
sense of safety than transferring assets outright to children as gifts.
In this example, when the husband and wife pass away, any assets which
were put into the irrevocable trust are not included in the person's
estate for the calculation of Medicaid assistance, the estate tax, or
probate. The state can only lien assets included in the probate estate
to pay for long-term medical care. The probate estate includes assets
owned individually at the time of death. Assets owned by an irrevocable
trust are not owned in the individual's name and therefore are not
part of the probate estate. Therefore, these assets are not subject to
Medicaid's estate recovery provision. That means, ultimately, that
assets in the trust will be preserved for the person's heirs.
Many couples also consider using a life estate to protect their homes rather
than transferring property into a trust. Creating a life estate requires
executing a deed that transfers ownership of the property to the grantee,
yet gives the owners the legal right to live on the property as long as
either of them lives. This approach can ultimately protect homeowners
from having the property taken to pay for long-term care, but can also
create huge unnecessary problems.
If the children experience financial difficulty during the life of the
parents, creditors may be able to put a lien on the residence. They could
not force a foreclose on the lien while the parents were alive, but the
existence of the lien would still cause problems for the children when
the property transfers to tem following the death of both parents. If
a child gets divorced, the house in a life estate may also be considered
a marital asset and the ex-spouse could get half.
Life Estate Creates Conflicts of Interest
A life estate also means that the parents cannot sell the home without
the consent of all children that hold the remainder interest. A child
that wants to keep the home in the family can stop the parents from selling.
Life Estate Creates Capital Gains Issues
If the parents sell after transferring the property to their children,
the children would be assessed a capital gains tax. In 2013, the capital
gains tax rate on real estate was 25%. The tax is based on the difference
between the purchase price of the house and the sales price. Consider
the hypothetical couple with two children and a house worth $500,000.
Assume the property cost $100,000. If the parents transfer the property
to their children, retaining a life estate, and later decide to sell,
all four individuals are considered owners. The children would be assigned
approximately 50% of the cost basis in the property and approximately
half of the sale proceeds. That means that each child would be assumed
to have earned income of $100,000 from the sale, minus $25,000 of the
cost basis, which leaves a capital gain of $75,000. Each child would then
have to pay approximately $18,750 in capital gains taxes on the parents' home.
This unjust outcome becomes even more unfair when the capital gains tax
exclusion is factored into the equation. The law allows a capital gains
tax exclusion of up to $500,000 for a married couple on a person's
primary residence. That means, if the parents lived in the property and
used it as their home for at least two years during a five-year period
before the sale, they are allowed to exclude up to $500,000 of the sale's
proceeds from being taxed. Since each parent's share of the sale proceeds
is only $100,000, they pay no taxes - yet their children get a tax bill
solely because the parents transferred the property to them before selling
it. Also bear in mind that, had the parents not transferred the property
to their children, their capital gains would have been $400,000, and no
capital gains taxes would have been owed. When looking at these numbers,
it is clear that transferring the property to the children and retaining
a life estate may not benefit the children. It may also cause strife if
the children refuse to sell because of the potential tax liability. Remember
that the parents cannot sell without the children's agreement.
Irrevocable Trust Benefits vs. a Life Estate
If the couple decided instead to transfer the home to an irrevocable trust,
they could still retain a joint life estate. However, the remainder interest
would belong to the trust. In this scenario, the parents could sell the
home without their children's consent and without facing the capital
gains tax issues in the prior example. The couple would be considered
the owners for income tax purposes and could take the full benefit of
the capital gains exclusion following a sale. They would pay no capital
gains tax. In addition, creditors of the children would have no access
to the property during the parents' lives and the trust would give
the couple some protection against their own creditors.
For those who avoid irrevocable trusts because they worry about extra taxes,
it is true that if you don't set it up correctly a trust with earned
income must file an income tax return. Earned income may include rental
income, interest or dividends. However, if it is setup correctly; eg.
if the spouses retain a limited power of appointment, they should not
incur any increased tax liability as a result of establishing the trust.
A special power of appointment typically means that the grantor has special
powers in the trust that do not affect its asset protection benefits.
A special limited power of appointment is considered a grantor trust,
which does not need to pay income taxes. The income flows through the
trust to the grantors, or the husband and wife. They would pay taxes on
trust income at the lower individual income tax rate rather than trust
rates. In essence, the husband and wife would pay the same income tax
that they paid prior to establishing the trust.
Potential Capital Gains Benefits
The estate inclusion also provides a significant tax benefit known as a
step-up in basis for capital gains tax purposes. If a parent transfers
an asset that has increased in value, the parent's cost basis carries
over to the child. That means, when the asset is eventually sold, the
child will be assumed to have taken the asset at the same price as the
parents and required to pay capitals gains taxes on the full increase
in value. Similar to our previous example, if the parents obtained their
stock at $100,000 and transferred it as a gift to the children with a
value of $500,000, the children are given a cost basis of $100,000. If
they later sell the stock for $500,000, the children will realize and
recognize a $400,000 capital gain, which translates to approximately $100,000
in federal capital gains tax liability.
Instead, if the parents transferred the stock to an irrevocable trust,
the stock would be includible in the gross estate of the parents and given
a step-up in basis. The step-up in basis means the stock is valued as
of the date of the parent's death, not at the time of purchase. Similarly,
if the parents put their home into an irrevocable trust with a fair market
value of $500,000, the children's cost basis will also be $500,000.
Therefore, if the children sold the home soon after their parents'
deaths, there would be little or no capital gains to be taxed. As far
as the children are concerned, this is a much more desirable outcome.
This benefit is not available to individuals who transfer assets outright
to their children as gifts.
In conclusion, the irrevocable trust is the only type of trust that allows
parents to transfer assets in a manner that will provide protection from
their creditors, including the costs of long-term care, and their children's
creditors (including ex-spouses) while allowing the parents to benefit
from the assets comprising the trust during their lives. In addition,
this trust provides some estate and income tax benefits for both the parents
and their heirs.