by Thomas D. Begley, Jr., CELA

An Income Only Trust can be designed as a grantor trust. The trust assets are unavailable for Medicaid, but there are some potentially significant tax benefits to the grantor. The Internal Revenue Code contains certain requirements for a grantor trust.[1] 

Income Tax. Income is taxed at the grantor’s individual tax rate, which is usually less than the trust’s compressed tax rate.

Capital Gains Tax. Capital gains tax treatment is maintained. This is particularly important if the trust is funded with a primary residence. The §121 exclusion from capital gains tax can be maintained. The trust must contain a provision that the trustee must allocate the gain on the sale of the home to principal and not to income.

The benefit of the capital gains tax can be achieved for non-home appreciated assets as well.

Gift Tax. An Income Only Trust can be designed in such a way that a transfer into a trust can be either a gift or not a gift. If the grantor desires that the transfer be considered a gift for tax purposes, a gift tax return would be filed based on the present value of the gift. This would be the value of the assets transferred, less the value of the grantor’s retained interest in the income stream.

Estate Tax. Since the trust is a grantor trust, the entire value of the estate would be included in the grantor’s estate for federal estate tax purposes.[2]

Because the assets are included in the estate of the grantor, the estate should receive a step up in tax basis as to trust assets to the fair market value of the assets as of the grantor’s death. To achieve the step up in basis, the trust should contain a limited power of appointment on death. In many cases, this is a significant advantage over outright transfers to children.

Estate Recovery. The assets in the Income Only Trust would not be subject to estate recovery in states having a probate definition of estate, but would be included in states having a broad definition of estate for estate recovery purposes.

[1] I.R.C. §§ 673–677.

[2] I.R.C. §§ 1014, 2036, 2038; Treas. Reg. §§ 1.1014-2(a)(3), (b).

by Thomas D. Begley, Jr., CELA

Seventy percent of Americans will require some form of long-term care be it nursing home, assisted living or home care. The cost of this care can range from $20 per hour or more for home care to $10,000 – $12,000 per month for nursing home care. Before becoming eligible for Medicaid in a nursing home or assisted living facility, an individual must list their home for sale and if it does not sell during the individual’s lifetime, Medicaid will place a lien on the home on death. If the individual is receiving home care paid by Medicaid, then he or she will not have to sell the home at that time, but it will be subject to estate recovery on death.

The typical strategy to protect the home is to deed it to a child or children. The individual then waits five years and applies for Medicaid. One problem with this strategy is that there are risk factors. If the home is transferred to a child, the home could be lost, in whole or in part, if:

• The child has creditors who sue the child;
• The child winds up in a divorce; or
• The child is on public benefits and the transfer may cause the child to lose those benefits.

There are also significant tax disadvantages to transferring a primary residence to a child.

• Capital Gains Tax. If a parent gives the house to the child, the parent’s cost basis carries over to the child. If the parent paid $200,000 for a home many years ago and it is now worth $400,000, the $200,000 cost basis carries over to the child. If the child then sells the home, he or she must pay capital gains tax on the $200,000 profit.

• Section 121 Exclusion. If the parent sells the home, he or she has a $250,000 exclusion from capital gains tax, if single, and a $500,000 exclusion, if married.

• Step Up in Basis. If the parent dies and leaves the home to the child, the child receives a “step up” in basis, which means that the child’s basis is the fair market value of the home on the parent’s death. Let’s suppose the home is still worth $400,000 on the parent’s death. Now the child’s basis would step up to $400,000, and if the child sold the home right away, there would be no gain and no capital gains tax.

• State Real Estate Tax Benefits. In New Jersey there are a number of real estate tax benefits attendant to ownership of a primary residence. These include: Homestead Tax Rebate, Senior Citizen’s Deduction, Veteran’s Deduction, Veterans Exemption for Disabled Veterans, and a Tax Freeze. If the home is transferred to a child and the child does not occupy the home, then all of these benefits are lost. Even if the child does occupy the home, many of these benefits would be lost.

• A better solution would be to transfer the home to a trust for the benefit of the child. The primary residence exclusion, step up in basis, and state real estate tax benefits can all be preserved while eliminating the risk factors.