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The IRS Quietly Changed the Rules on Your Children’s Inheritance

Property, such as your home, held in an irrevocable trust “that is not included in the taxable estate at death” will no longer receive a step-up in basis.

An increasing number of individuals are considering placing their homes into irrevocable trusts as a means of protecting their assets from potential Medicaid or VA Aid and Attendance spend down. While this strategy offers certain benefits, it is crucial to be aware of potential tax implications and the impact it may have on the inheritance received by children in light of the IRS issued Revenue Ruling 2023-2 released in March.

Prior to the issuance of this ruling, assets passing to beneficiaries through an irrevocable trust would receive a step-up in basis, thereby eliminating any capital gains taxes that would otherwise be owed. The amount of capital gains owed is determined largely by the difference between the value at the time of purchase and the value at the time of transfer.

This new ruling by the IRS states that property held in an irrevocable trust is no longer included as part of the taxable estate, thus it no longer will receive a step-up in basis.

The dilemma now becomes do you allow your home to be liquidated so that you can take advantage of long-term care or still try to protect it so the children will have something when you pass.  Looking at the numbers, selling your house would generate little tax consequences for the existing homeowner since there is a $250,000 capital gain exemption per homeowner, maxed at $500,000. Putting that same home into an irrevocable trust would make the gain on the home sale taxable at the trust tax rate, currently 37%. The other 63% of the gain plus the full original purchase price would be distributable to the heirs.

As you can see, the heirs still receive an inheritance when the home is placed into the trust — just not as large as anyone had expected.

At first glance the IRS ruling is a cause for rethinking your asset protection strategy, but for most it should not change the strategy of using an irrevocable trust.

Some families choose to add their children to the house title or to quit claim deed the house to the children to protect the asset from Medicaid drawdown. Before attempting these simple options, I recommend you have a conversation with an eldercare attorney.

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