What Your Financial Professional Doesn’t Know About Trusts And Taxes
Benjamin Franklin once wrote: “Nothing can be said to be certain, except death and taxes.” And although this quote became famous due to how relatable the idea is, at the same time, it’s often the case that very little is understood about how the two certainties go hand in hand. Especially when it comes to the pros and cons of a trust for estate planning. Hate to say it, but we’ve had a number of very qualified financial advisors and even CPAs give clients the wrong information about trusts and when they’re taxed.
So, we’re going to break it down with some basics for you here, starting with answers to a common question:
Does an irrevocable trust create a capital gains tax trap?
Now, if that first question made you cross-eyed, we recommend starting on a past blog post to understand: What’s an irrevocable trust. Or, jump here to our glossary of common terms.
Still here? Let’s dive in.
So, we understand that if you buy property and then years later decide to sell it for more than you originally paid, your gained income is taxable. That’s correct.
Also, if instead of selling it, you decide to transfer or gift that property to a loved one and then they sell it for more than you originally paid, they would pay the tax on capital gains.
However, let’s say you buy a property and stay the owner of it (or in control of it) until death; if it gets inherited by a family member who decides to sell it at its date of death value (even if that’s more than you originally paid), they do not need to pay that capital gains tax.
The reason you don’t pay a tax is because the cost basis (or, the amount you paid for it) that is used to calculate capital gains gets “stepped-up” to its value on the date of death.
When you have an irrevocable trust, do you get a step-up in basis?
Financial advisors often assume “no” across the board; however, the answer can be yes, BUT with the right type of trust. (This legal navigation is where it becomes crucial to work with an experienced legal professional.) Certain irrevocable trusts still give you enough control over the trust assets to trigger the important step-up in cost basis.
For instance, with a Medicaid Trust, which is a type of grantor trust, you do get a step-up in basis. This is the “bread and butter” tool we use for middle-class asset protection. On the other hand, you don’t get a step up in basis with a non-grantor trust, a type of irrevocable trust for very high-net worth people (whose bigger concern is Estate and Gift Tax). Confusion often sets in when a financial advisor thinks that the rules for all irrevocable trusts are the same–which we have seen enough of to inspire this article!
The bottom line?
You can set up an irrevocable Medicaid trust that won’t cause you or your family to pay tax on property that’s inherited after your death. But you should absolutely schedule a call with an experienced attorney to find out the best means of asset protection for you and your family.