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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.
Here’s why the wording of that is key.

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(Image credit: Getty Images)

By Lindsay N. Graves, Esq.
published July 04, 2023

In March, the IRS issued Revenue Ruling 2023-2, which had a substantial impact
on estate planning, particularly where an irrevocable trust is involved. In the
last decade or so, more families have begun utilizing irrevocable trusts to
protect their assets from spend-down in order to qualify for government
benefits, such as Medicaid and VA Aid and Attendance.



Prior to the issuance of this ruling, it was unclear whether 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.
Historically, assets that are disposed of during an individual’s lifetime are
subject to capital gains taxes on the increase in value of that asset over time.
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.




An exception to the obligation of capital gains taxes has been when assets pass
at the death of the owner to their beneficiaries. The death of the owner bestows
upon the recipients a step-up in basis, so they inherit the asset as if it had
been purchased at the current fair market value, not the value at the time the
asset was actually purchased. This eliminates any capital gains, and so no taxes
become due.


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WHAT ABOUT AN IRREVOCABLE TRUST?

But what to do about assets in an irrevocable trust? They are not currently held
by the purchaser of the asset, nor have they passed to the beneficiaries. Prior
to March 2023, such transfers from the trust at death have been generally
receiving the step-up in basis. But that may not be the case any longer. This
new ruling by the IRS states that property held in an irrevocable trust that is
not included in the taxable estate at death will not receive a step-up in basis
any longer.

At first glance, it sounds like anyone who does irrevocable trust planning will
be subjecting their children to additional taxes. You may be wondering why
anyone would do irrevocable trust planning in the first place. As Americans are
aging and living longer, more are finding themselves in need of long-term care
to the tune of, on average, $6,500 to $10,000 per month, depending on where you
live and what level of care you need.



Very few families can afford to pay that out of pocket without depleting their
life savings, which means turning to programs like Medicaid or VA Aid and
Attendance to help with the cost. However, before you can qualify for such
programs, you will be expected to go through a spend-down of your assets to a
level set by the state in which you reside. One of the only tools that can
protect assets from being subject to the spend-down process is an irrevocable
trust.

Does asset protection planning now mean that to avoid the spend-down, you will
have to subject your children to additional taxes? Maybe. The key part of the
IRS’ decision is that only those assets that are held in an irrevocable trust
that are not otherwise included in your estate at death for estate tax purposes
will lose the step-up in basis. What does that mean? Essentially, in a move that
is likely meant to make sure that as many estates as possible become subject to
paying estate taxes, if you establish an irrevocable trust that is not set up
properly, you will lose the step-up in basis.


HOW AN IRREVOCABLE TRUST IS SET UP IS IMPORTANT

However, it is possible to establish an irrevocable trust that allows for any
assets of the trust to still be included in the taxable estate at death —
keeping in mind that most families, even with the inclusion of the value of
their home, will not have estates large enough to be subject to estate taxes.
Thus, your assets can be protected from spend-down due to long-term care,
avoiding capital gains taxes and estate taxes and passing to your children
tax-free. It just takes very careful planning.

By way of example, let’s look at a couple whom we will call Tom and Jane. Tom
and Jane purchased a home (not a primary residence) in 1975 for $100,000. If
that house is now worth $250,000 and they sell that house, they will owe capital
gains taxes on the growth of $150,000. (An important note, if this property had
been a primary residence, Tom and Jane would owe capital gains only on any
growth exceeding $500,000.) In contrast, had Tom and Jane transferred their
property to an irrevocable trust, prior to March of 2023, the trust could sell
the house from a cost basis of $250,000, not $100,000 (because of the step-up in
basis), so no capital gains would be due when the trust then distributes those
proceeds to Tom and Jane’s children. Post-Revenue Ruling 2023-2, unless the
trust is properly worded to ensure that the $250,000 value of the home is
included in Tom and Jane’s taxable estate, the children will owe capital gains
on $150,000. 

Most families will not find themselves subject to estate tax when the value of
their home is included because the current federal estate tax is only applicable
to estates valued at $12.92 million or more. It will be more likely to impact
families when the estate tax limit is lowered in 2026 to about half of that
exemption amount. (For more about this, see the article What to Do Before the
Tax Cuts and Jobs Act Provisions Sunset.)

If you currently have an irrevocable trust or are interested in learning more
about one, seek legal counsel from an attorney who is knowledgeable in both
elder law and estate planning. It is also always a good idea to get your tax
professional involved in the conversation so that nothing is missed in your
plan.

The world is becoming more complex, as are the tax laws, but you (and your
children) can still come out ahead with sound advice and planning.

Editor's note: This story has been updated to clarify the example of Tom and
Jane.


RELATED CONTENT

 * Why Do I Need a Trust?
 * Eight Types of Trusts for Owners of High-Net-Worth Estates
 * What Assets Should You Put (or Not Put) in Your Trust?
 * Four Reasons You Don’t Need a (Revocable) Trust
 * Four Reasons Retirees Need a (Revocable) Trust

DISCLAIMER

This article was written by and presents the views of our contributing adviser,
not the Kiplinger editorial staff. You can check adviser records with the SEC or
with FINRA.



Lindsay N. Graves, Esq.
Social Links Navigation
Partner/Owner, The Graves Law Firm

Lindsay Graves, founding partner of The Graves Law Firm, is passionate about
assisting families through the challenges of the aging process to ensure dignity
and financial preparedness with a comprehensive and compassionate approach. Her
law firm focuses on helping clients to articulate their goals for asset
preservation and long-term care and making them a reality, avoiding bankruptcy
and securing wealth for loved ones. Lindsay and her team pride themselves on
building and maintaining long-lasting relationships with their clients and
families.



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