What are the Capital Gains Consequences if I Put My House in an Irrevocable Trust?
I live in Illinois and am 66 years old and a widow. Many years ago, an estate planning lawyer recommended I put my home in an irrevocable trust (with my daughter as the trustee) in order to protect it in case I end up on Medicaid at some point in my life. He said just having it in a revocable trust would not protect it in the same way. My question is when I die and my daughter eventually sells the house, will taxes paid on the gains be taxed at the trust rates which are much higher than individual tax rates? I don’t want to make things unnecessarily complicated for my trustee nor do I want her to end up paying higher tax rates. Is the irrevocable trust still the best option for protection?
To answer your last question first, probably yes. The irrevocable trust can be drafted so that the house receives a step-up in basis upon your death. This is normally what happens when property is passed at death. The basis is what you paid for the house plus the value of any improvements. So, for example, if you bought the house for $250,000 and added an addition for $100,000, the basis would be $350,000. The capital gain is the difference between the sale proceeds and the basis. So, if you sold this house for $600,000, you would have $250,000 of gain ($600,000 – $350,000 = $250,000). If you gave the house to your daughter, she would have the same basis as you and if she realized $250,000 of gain she would have to pay taxes on it (unlike you who, as the homeowner, can exclude the first $250,000 of gain).
However, if your daughter inherits your house and, in our example, it has a fair market value of $600,000 on your date of death, that will be the new basis. If your daughter sells the house at that price, there will be no gain and no tax.
An irrevocable trust can be drafted with either result — that it’s a gift to your daughter and she receives the house with your basis or that there’s no completed gift when you create the trust and your daughter receives a step-up in basis. We can be almost sure that the attorney will draft the trust in the second way, but you should ask to be certain.
Other non-tax issues to consider in transferring your house to your irrevocable trust:
- It will cause you to be ineligible for Medicaid for the five years following the transfer.
- You would not be able to tap into the equity in the house for your needs.
- Your daughter would control the trust and your home.
- If the trust were to sell the house during your life, it may or may not qualify for the $250,000 exclusion on capital gains — another issue to discuss with your attorney.
Given these issues, it often makes more sense to use an irrevocable trust if you have substantial other assets to pay for your needs. Other options to consider to protect the house are a life estate or, in some states, a transfer on death or “lady bird” deed. (On the latter, I don’t know about Illinois in particular.)