Estate planning for blended family

Question:

My wife and I jointly own our residence as tenants by the entirety. I have two adult children and grandchildren from my first marriage and two adult children and grandchildren from my second marriage. Our current wills do not include testamentary trusts and give the spousal survivor all residual property that is not jointly owned or covered by a designation of beneficiary form. If there is no spousal survivor, the residue is divided equally among my heirs and my wife’s heirs. Our residence is our most valuable asset. Is there any tax or other reason to put our residence in a living trust (revocable or irrevocable) before death or to revise our will to include the residence in a testamentary trust? Also, would my heirs pay fewer federal income taxes on the future capital gain if a trust were the “seller” of the property after we have both died rather than the estate?

Question:

Let’s talk about taxes first and “other reasons” second. There’s no tax reason to make any change and there’s no benefit to a trust selling property after you and your wife have both died rather than the estate doing so. In fact, there could be a tax cost to taking this step depending on how the trust is written.

The house will receive a one-half step-up in basis when the first spouse passes away and a 100 percent step-up when the second spouse passes away. A step-up in effect eliminates capital gains so that when those inheriting property sell it the do not have to pay any taxes on the gain. The house will receive a 100 percent step up upon the death of the surviving spouse both if it is held in your names or in a revocable trust as long as the trust remains revocable by the surviving spouse.

If instead the trust becomes irrevocable upon the death of the first spouse so the surviving spouse cannot revise the trust, it may not receive the second step-up in basis or may receive it only for their half the property. Likewise, dividing the house ownership in half with the share of the first spouse to pass away going into a testamentary trust or a separate inter vivos trust also could mean that this one-half share does not get a second step-up in basis upon the death of the surviving spouse. Whether or not it does depends on how the trust is written, which can get complicated.

So, using a trust may have adverse tax consequences depending on how the trust is written.

Turning to other reasons you might want to use a trust, I can think of a couple. First, you and your wife share some children and grandchildren and not others. If you have any concern that she would change her estate plan to diminish the inheritance of the children and grandchildren you don’t share in common, then a trust could help protect them. It’s not unusual for older property owners to fall under the undue influence of family members or others.

Second, testamentary trusts fall into a special safe harbor for Medicaid purposes. Anything you leave in a testamentary trust for a surviving spouse will not have to be spent down should they need Medicaid coverage to pay for nursing home care and will not be subject to Medicaid estate recovery upon their death.

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