Irrevocable trusts are not limited to real property transfers. Liquid assets may also be transferred to irrevocable trusts 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 five-year “lookback” period in order to take advantage of irrevocable trust planning.
As a hypothetical 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, desire to protect these assets from the high cost of long-term, institutionalized care. They are also concerned about releasing full control over these assets to their daughter and furthermore do not want her to have to endure a long and expensive probate process when they pass away.
Proper irrevocable trust planning can alleviate all of their concerns. Through a transfer of these assets to an irrevocable trust, the couple can (1) remove the assets from their countable asset tally (assuming they make it past the five-year lookback), thus qualifying for Medicaid if long-term care is eventually needed, (2) retain control over the assets, receiving net income from the liquid assets, and maintaining 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. Overall, irrevocable trusts provide individuals with greater control and discretion than transferring the property outright to a child, and allow for long-term care protection and probate avoidance.
Tax Benefits of Irrevocable Trusts
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. With the grantor trust designation comes several benefits. 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 principle residence (up to $500,000), should they decide to sell the property. In other words, they would only have to pay capital gains taxes on the portion of the gain exceeding $500,000. The transfer of the property to an irrevocable trust does not change this. And provided the sale proceeds are funneled directly into the trust, they too will be protected, with the lookback period unaffected by the transaction. 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 trust 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. Practically speaking, this means that a sale of Mom and Dad’s home by the inheriting children will be unlikely to result in any capital gains taxes owed, meaning the potential for significant tax savings on the sale of any asset that has appreciated over the years.
While the trust assets are includible in one’s gross taxable estate, they are not includible in the probate estate. In Rhode Island, the trust assets will, the trust assets will thus have the added protection of not being reachable as part of Medicaid’s “recoverable estate” for any services provided over the course of an institutionalized spouse’s lifetime, since the recoverable estate does not extend to non-probate assets. Neither will our couple’s daughter have to spend the time and money involved with probating the trust assets, as they would pass to her outside of the probate process.
In conclusion, irrevocable trust planning offers all of the benefits one generally associates with an outright transfer of property to children or other family members, without a lot of the downside that comes with this much “simpler” planning device. Concerns about control over assets can be eliminated with proper drafting, and one also receives significant probate, estate and tax planning benefits with the irrevocable trust.