2013-12-27 / Senior Savvy

Irrevocable Trusts Offer Planning and Tax Benefits

By Chad E. Nelson, Esq.

While most people have heard of the estate planning tool of irrevocable trusts, they’re nonetheless frequently misunderstood. The “irrevocable” nametag often scares people away, as fear of relinquishing control over assets and the inability to change trust provisions can be too large a leap for some to make. A few points of clarification regarding irrevocable trusts, and the common misconceptions surrounding them, will give skeptics a better picture of what is really involved.

Many individuals are familiar with the seemingly uncomplicated transaction of deeding one’s house to their children to remove the house from the nursing home’s reach should long-term care ultimately be necessary. However, deeding property to an irrevocable trust also provides long-term care protection. A trust also offers other benefits, including allowing one’s children to be the ultimate beneficiaries of the property, while avoiding creditor issues associated with a child’s divorce or other liability (a real concern with an outright transfer of property to them). With regard to the irrevocability of these trusts, a simple device known as a “limited (or special) power of appointment” allows the grantors to make slight adjustments to the trust, such as altering beneficiary provisions and even selling the property during life. At the same time, the property is removed from the probate estate and is therefore not considered an available asset for long-term care qualification. So long as the power of appointment is limited in an appropriate fashion, the irrevocable trust does not run afoul of Medicaid regulations.

Irrevocable trusts are not limited to real estate transfers. Liquid assets may also be transferred into the trust in order to preserve them for long-term care planning purposes. With both types of assets though, the transferor of the assets must get through a “lookback” period.

As an example, a healthy couple, ages 68 and 66, who have one daughter, own their primary residence valued at $250,000, and have other financial accounts and investments totaling $250,000, want to protect these assets from the high cost of long-term, institutionalized care. They are also concerned about releasing control over their assets to their daughter and do not want her to have to endure a long and expensive probate process when the time comes.

Irrevocable trust planning can alleviate all of their concerns. Through a transfer of their assets to an irrevocable trust, the couple can (1) remove the assets from their countable asset tally (assuming they make it past the lookback period), thus qualifying for Medicaid if long-term care is eventually needed; (2) retain control over the assets, receive net income from the liquid assets, and maintain the ability to live in the home during their lifetimes; and (3) remove these assets from their probate estate upon the surviving spouse’s death.

Also noteworthy are the tax benefits that come with irrevocable trust planning. Because these trusts, if structured properly, are “grantor trusts,” the couple in our example would still be considered owners of the home for tax purposes. The grantor trust designation offers several advantages. Provided the couple has owned and lived in the property for two of the previous five years, they would be able to take advantage of the IRS capital gains tax exclusion on a sale of the principal residence (up to $500,000) should they decide to sell the property. Also, income earned by the liquid assets in the trust will be taxed at the lower individual rates of the grantors, instead of at the higher tax rate for trusts.

A further tax benefit provided by the irrevocable trust’s grantor trust status is a stepped-up basis in assets for the beneficiaries who ultimately receive them. Upon the passing of the surviving spouse in our example, the trust assets are included in the surviving spouse’s gross estate (for tax purposes). This is important, because the children inheriting the trust assets will take them at a cost basis equal to the value of the assets at the date of the surviving spouse’s death. This means that a sale of Mom and Dad’s home by the inheriting children will be unlikely to result in any capital gains liabilities.

In conclusion, irrevocable trusts offer all of the benefits one generally associates with an outright transfer of property to children or other family members, without a lot of the downsides inherent in that “simpler” planning device.

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