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Using Trusts to Create an Effective Elder Care Plan

Introduction

In order to qualify for Medicaid, an applicant is required to meet specific resource and income standards. For individuals applying for either nursing home or community Medicaid coverage in 2014, the resource threshold (the maximum amount of “non exempt” assets an individual can have in his or her name in order to qualify for Medicaid) is $14,550 in New York State. Certain assets, such as a home, are exempt assets provided that either the Medicaid applicant or his spouse occupy the premises as his or her primary residence.
The Deficit Reduction Act of 2005 (the “DRA”) imposed a five-year “look-back” for individuals applying for nursing home Medicaid coverage. As a general rule, asset transfers made by the applicant or his or her spouse during the five year period prior to the submission of the Medicaid application will result in a period of Medicaid ineligibility. It is important to note that under current New York law the Medicaid look-back rules apply only to nursing home Medicaid but not to applications for community care (i.e. an individual may transfer all of her assets on the 31st day of the month and be eligible for community Medicaid coverage on the 1st day of the following month). Because of Medicaid’s resource limits and five-year look-back rules, it is important that individuals who wish to protect and preserve their assets complete a Medicaid plan in a timely manner in order to prevent the imposition of a penalty should future nursing home care be required.

There are various planning techniques that can be utilized when creating an effective asset preservation plan. In evaluating when and how to transfer assets, it is crucial that the elder law attorney carefully consider both the tax and non-tax ramifications. This article evaluates various gifting techniques from the perspective of maximizing available tax benefits.

Outright Gifting

Gifting assets to children or other loved ones outright is the simplest method of transferring resources. However, this technique will frequently result in significant adverse tax consequences. As described in greater detail below, under IRC Section 1015(a), the donor’s basis in the gifted asset will carry over to the donee. The donee/child will be responsible for income taxes on the realized gain when the asset is sold. If the child is in a higher income tax bracket than the donor/parent, the ultimate income tax obligation could be substantially greater if the asset is sold by the child rather than the parent. This is especially important in light of the recent tax increases enacted by the American Taxpayer Relief Act of 2012.

There are additional concerns if the gifted asset is a residence. Transferring a residence by outright gift to a child may result in the loss of real estate tax exemptions such as the enhanced star, senior citizens or veteran’s exemptions. In addition, the child may not qualify for the IRC Section 121 exclusion which permits an individual to exclude $250,000 of profit upon the sale of a principal residence ($500,000 in the case of a married couple).
One of the most important issues to consider regarding an outright gift is the loss of the step-up in basis. Ordinarily, the tax basis of assets owned by an individual as of the date of his or her death is ‘stepped up’ or increased to the asset’s fair market value as of the date of death. Retaining the step-up in basis is a very powerful tax planning tool, as it can effectively eliminate any income tax liability if the asset is sold soon after the death of the parent. An asset that is gifted by the parent during his or her lifetime will retain the donor’s basis and will not qualify for a step-up in basis upon the parent’s death. As stated above, the child will be obligated to realize the gain upon the later sale of the asset based on the parent’s carryover basis.

Life Estate

A related strategy for creating an outright gift that is commonly utilized with respect to a residence is to transfer the property subject to a life estate reserved by the donor parent. Reserving a life estate allows the parent to retain the right to use and occupy the property for the rest of his or her life. It should allow the parent to retain many of the tax benefits discussed above such as available real estate tax exemptions and the basis step-up.
A key implication that must be considered is the gifted residence’s impact on the donor’s taxable estate. Due to the fact that the donor retains an interest in the house, the value of the house will be included in the taxable estate of the donor. Thus, although it will qualify for the step-up in basis, there will be an increase in the donor’s taxable estate which may result in increased federal and state estate taxes.

Furthermore, if the house is sold during the parent’s lifetime, the children will be responsible for the capital gains taxes on the profit attributable to the value of the remainder interest based on the difference in the sale price and the parent’s carryover basis. It is important to note that as the parent ages, the proportionate value of the life estate decreases and the proportionate value of the remainder interest increases. Accordingly, the taxes attributable to the profit resulting from a sale of the remainder interest will also increase. Selling the property during the parent’s lifetime could present a potentially significant financial burden for the children. Moreover, it is important to note that the Section 121 exclusion will be limited to the value of the life estate only. If the value of life estate is less than $250,000 ($500,000 in the case of a married couple) use of the Section 121 exclusion will be limited.

Although it is beyond the scope of this article, there are significant non-tax implications that must also be considered when transferring assets. There are a number of significant issues frequently overlooked when gifting an asset or transferring a house subject to a life estate. Creditor and bankruptcy issues of the child/donee, the unintended consequences of a child predeceasing the parent, divorce of a child/donee and the disability of a child or grandchild, are some of the issues that should be carefully considered prior to making the gift.

Irrevocable Medicaid Qualifying Trust

As with other gifting strategies, an Irrevocable Medicaid Qualifying Trust will permit the parents to protect and preserve their assets should long term community or nursing home care be required. With proper drafting, the gifted property held in the trust should remain eligible for available tax benefits and can also be protected in the event a child faces legal and/or financial difficulties. In order for the trust assets to be viewed by Medicaid as unavailable to the parent, (1) the trust must be irrevocable and (2) the parent/settlor may not serve as trustee. Furthermore, any principal or income that pursuant to the terms of the trust can be distributed by the trustee to the parents will be considered available for Medicaid purposes.

When creating a Medicaid Qualifying Trust, the goal should always be to protect assets while maximizing available income and estate tax benefits, such as the Section 121 exclusion, star exemption, and veteran’s benefits. In many situations, it may be beneficial to construct the trust in a manner that will allow the transfers to be treated as a completed gift for Medicaid purposes, but as an incomplete gift for tax purposes. In other situations, it might be beneficial to structure the transfer as a completed gift for both Medicaid and tax purposes. Such circumstances may include the scenario where the total value of the estate is in excess of the applicable state and/or federal estate tax exemption levels or where the basis of the transferred property is high, and a later sale utilizing the carryover basis would not result in significantly increased capital gains taxes. Another circumstance where a completed gift might be beneficial is where the asset generates significant income for the settlor, which could be detrimental in the event the settlor enrolls in Medicaid at some point in the future.

Individuals with significant assets may, with the aid of counsel, determine that it is beneficial to establish two or more trusts whereby certain assets, such as those with a high basis or those that generate significant income, are transferred out of their names for both estate tax and Medicaid purposes while other assets, such as a residence and those assets with a low tax basis remain part of their estate for estate and income tax purposes. The drafting attorney should also consider including other important estate tax planning techniques for inclusion in the trust, such as bypass/credit shelter provisions, if applicable.

Conclusion

Establishing a viable plan to protect and preserve assets involves the development of a comprehensive strategy both from an elder care and tax planning perspective. A plan cannot be designed and executed without consideration of both the tax and non-tax implications. In many situations, a properly drafted Medicaid Qualifying Trust will be the most effective way to achieve all of the planning objectives.

This article first appeared in the February 2014 edition of the Nassau Lawyer and is reprinted with permission by the Nassau County Bar Association.