When you say the word “trust” many people think that trusts are only used by the uber rich to protect their millions of dollars but that is very far from the truth. Yes, extremely wealthy families do use trusts to reduce the size of their estate but there are also a lot of very good reasons why it makes sense for an average individual or family to establish a trust. The two main reasons being the avoidance of probate and to protect assets from a long-term care event. This article will walk you through:
- How trusts work
- The difference between a Revocable Trust and an Irrevocable Trust
- The benefits of putting your house in a trust
- How to establish a trust
- What are the tax considerations
What Is A Trust?
When you establish a trust, you are basically creating a fictitious person that is going to own your assets. Depending on the type of trust that you establish, the trust may even have it’s own social security number that is called a “tax ID number”. Here is an example. Mark and Sarah Williams, like most married couples, own their primary residence in joint name. They decide to establish the “Williams Family Trust”. Once the trust is established, they change the name on the deed of their house from Mark and Sarah to the Williams Family Trust.
Revocable Trust vs. Irrevocable Trust
Before I get into the benefits of establishing a trust for your house, you first have to understand the difference between a “Revocable Trust” and an “Irrevocable Trust”. As the name suggests, a revocable trust, you can revoke at any time. In other words, you as the owner, can take that asset back. You never really “give it away”. Revocable trusts do not have a separate tax identification number. They are established in the social security number of the owner. A revocable trust is sometime referred to as a “living trust”.
With an Irrevocable Trust, once you have transferred the ownership of the house to the trust, it’s irrevocable, meaning you are never supposed to be able to take it back. The trust will own that house for the rest of your life. Now that sounds super restrictive but there are a lot of strategies that estate attorneys use to ease those restrictions and I will cover some of those strategies later on in this article.
In both cases, in trust language, the owner that gave property to the trust is called the “grantor”. I just want you to be familiar with that term when it is used throughout this article.
So why would someone use an Irrevocable Trust instead of a Revocable Trust? The answer is, it depends on which benefits you are trying to access by placing your house in a trust.
The Benefits Of A Revocable Trust Owning Your House
People transfer the ownership of their house to a revocable trust for the following reasons:
- Avoid probate
- They have children under the age of 25
- They want maximum flexibility
From our experience, this is the number one reason why people put their house in a revocable trust. Trust assets avoid probate. If you have ever had a family member pass away and you were the executor of their estate, you know how much of a headache the probate process is. Not to mention costly.
Let’s go back to our example with Mark & Sarah Williams. They own their house joint and they have a will that lists their two children as 50/50 beneficiaries on all of their assets.
When the first spouse passes away, there is no issue because the house is owned joint, and the ownership automatically passes to the surviving spouse. However, when the surviving spouse passes away, the house is part of the surviving spouse’s estate that will be subject to the probate process. You typically try to avoid probate because the probate process:
- Is a costly process
- It delays the receipt of the asset by your beneficiaries
- Makes the value of your estate accessible to the public
The costs come in the form of attorney fees, accountant fees, executor commissions, and appraisal fees which are necessary to probate the estate. The delays come from the fact that it’s a court driven process. You have to obtain court issued letters of testamentary to even start the process and the courts have to approve the final filing of the estate. It’s not uncommon for the probate process to take 6 months or longer from start to finish.
If your house is owned by a revocable trust, you skip the whole probate process. Upon the passing of the second spouse, the house is transferred from the name of the trust into the name of the trust beneficiaries. You save the cost of probate and your beneficiaries have immediate access to the house.
The Difference Between A Trust and A Will
I’ll stop for a second because this is usually where I get the question, “So if I have a trust, do I need a will?” The answer is yes, you need both. Anything owned by your trust will go immediately to the beneficiaries of the trust but any assets not owned by the trust will pass to your beneficiaries via the will. Trusts can own real estate, checking accounts, life insurance policies, and other assets. But there are some assets like cars and personal belongings that are usually held outside of a trust that will pass to your beneficiaries via the will. But in most cases, people have the same beneficiaries listed in the will and the trust.
Children Under The Age of 25
For parents with children under the age of 25, revocable trusts are used to prevent the children from coming into their full inheritance at a very young age. If you just have a will, both parents pass away when your child is 18, and they come into a sizable inheritance between your life insurance, retirement accounts, and the house, they may not make the best financial decisions. What if they decide to not go to college because they inherited a million dollar but then they spend through all of the money within 5 years? As financial planners we have unfortunately seen this happen. It’s ugly.
A revocable trust can put restrictions in place to prevent this from happening. There might be language in the trust that states they receive 1/3 of their inheritance at age 25, 1/3 at age 30, 1/3 at age 35. But in the meantime, the trustee can authorize distributions for living expenses, education, health expenses, etc. The options are limitless and these documents are customized to meet your personal preferences.
The revocable trust offers the grantor the most flexibility because they are not giving away the asset. It’s still part of your estate, it’s just not subject to probate. At any time, the owners can take the asset back, change the trustee, change beneficiaries of the trust, and change the features of the trust.
The Benefits Of An Irrevocable Trust
Let’s shift gears to the irrevocable trust. The benefits of establishing an irrevocable trust include:
- Avoid probate
- They have children under that age of 25
- Protect assets from a long-term care event
- Reduce the size of an estate
As you will see, the top two are the same as the revocable trust. Irrevocable trust assets avoid probate and are a way of controlling how assets are distributed after you pass away. However, you will see two additional benefit listed that were not associated with a revocable trust. Let’s look at the long-term care event protection benefit.
Protect Assets From A Long-Term Care Event
When individuals use an irrevocable trust to protect assets from a long-term care event, it’s sometimes called a “Medicaid Trust”. If you have ever had the personal experience of a loved one needing any type of long-term care whether via home health aids, assisted living, or a nursing home, you know how expensive that care costs. According to the NYS Health Department, the average daily cost of a nursing home is $371 per day in the northeastern region. That’s $135,360 per year.
For an individual that needs this type of care, they are required to spend down all of their assets until they hit a very low threshold, and then Medicaid starts picking up the tab from there. Now the IRS is smart. They are not going to allow you to hit a long term care event and then transfer all of your assets to a family member or a trust to qualify for Medicaid. There is a 5 year look back period which says any assets that you have gifted away within the last 5 years, whether to an individual or a trust, is back on the table for purposes of the spend down before you qualify for Medicaid. This is why they call these trusts a Medicaid Trust.
Medicaid Will Put A Lien Against The House
Now, your primary resident is not an asset subject to the Medicaid spend down. If your only asset is your house and you have spent down all of your other assets that are not in an IRA or qualified retirement plan, you can qualify for Medicaid immediately. So why put the house in an irrevocable trust then? While Medicaid cannot make you sell your primary residence or count it as an asset for the spend down, Medicaid will put a lien against your estate for the amount they pay for your care. So when you pass away, your house does not go to your children or heirs, Medicaid assumes ownership, and will sell it to recoup the cash that they paid out for your care. Not a great outcome. Most people would prefer that the value of their house go to their kids instead of Medicaid.
If you transfer the ownership of the house to an Irrevocable Trust, you can live in the house for the rest of your life, and as long as the house has been in the trust for more than 5 years, it’s not a spend down asset for Medicaid and Medicaid cannot place a lien against your house for the money that they pay out for your care.
So if you are age 65 or older or have parents that are 65 or older, in many cases it makes sense for that individual to setup an irrevocable trust, transfer the ownership of the house to the trust, and start the 5 year clock for the Medicaid look back period. Once you have satisfied the 5 year period, you are free and clear.
Frequently Asked Question
When I meet with clients about this, there are usually a number of other questions that come up when we talk about placing the house in a trust. Here are the most common:
If my house is in a trust, do I still qualify for the STAR and Enhanced STAR property tax exemption?
If my house is gifted to a trust, do my beneficiaries still receive a step-up in basis when they inherit the asset?
ANSWER: As long as the estate attorney put the appropriate language in your trust document, the house will receive a step up in basis at your death.
What if I want to sell my house down the road but it’s owned by the trust?
ANSWER: It depends on what type of trust owns your house and the language in your trust document. When you sell your primary residence, as a single tax filer you do not have pay tax on the first $250,000 of capital gain in the property. For married filers, the number is $500,000. Example, married couple bought their house in 1980 for $40,000, it’s now worth $400,000, which equals $360,000 in appreciation or gain in value. When they sell their house, they do not pay any tax on the gain because it’s below the $500,000 exclusion.
If a revocable trust owns your house, you retain these tax exclusions because you technically still own the house. If an irrevocable trust owns your house, depending on the type of irrevocable trust you establish and the language in your trust document, you may or may not be able to utilize these exclusions.
Many of the irrevocable trust that we see drafted by estate attorneys that exist for the purpose of avoiding probate and protecting asset from Medicaid are considered grantor trusts. The estate attorney will often put language in the document that protects the assets from Medicaid but allows the grantor to capture the primary residence capital gains exclusion if they sell their house at some point in the future. But this is not always the case. If you establish a irrevocable trust for your primary residence, it’s important to have this discussion with your estate attorney to make sure this specific item is addressed in your trust document.
Now, here is the most common mistake that we see people make when they sell their house that is owned by their irrevocable trust. You put your primary residence in an irrevocable trust six years ago so you are now free and clear on the five year look back period. You decided to sell your current house and buy another house or sell your house and put the cash in the bank. At the closing the buyers make the check payable to you instead of your trust. You deposit the check to your checking account and then move it into the trust account or issue the check to purchase your next house. Guess what? The 5 year clock just restarted. The money can never leave the trust. If your intention is to sell one house and by another house, at the closing they should make the check payable to your trust, and the trust buys your next house.
Does the trust need to file a tax return?
ANSWER: Only irrevocable trusts have to file tax returns because revocable trusts are built under the social security number of the grantor. However, if the only asset that the irrevocable trust owns is your primary residence, the trust would not have any income, so there would not be a need to file a tax return for the trust each year.
Are irrevocable trusts 100% irrevocable?
ANSWER: There are tricks that estate attorneys use to get around the irrevocable restriction of these trusts. For example, the trust could make a gift to the beneficiaries of the trust and then the beneficiaries turn around and gift the money back to the grantor of the trust. Grantors can also retain the right to change who the trustees are, the beneficiaries, and they can revoke the trust. Bottom line, if you really need to get to the money, there are usually ways to do it.
How To Establish A Trust
You will need to retain an estate attorney to draft and execute your trust document. For a simple revocable or irrevocable trust, it may cost anywhere from $2,000 – $5,000. Before people get scared away by this cost, I remind them that if their house is subject to probate their estate may have to pay attorney fees, accountant fees, appraisal fees, and executor commissions which can easily total more than that.
In the case of a long-term care event, I just ask clients the question “Do you want your kids to inherit your house that you worked hard for or do you want Medicaid to take it if a long-term care event occurs down the road?” Most people reply, “I want my kids to have it.” Putting the house in an irrevocable trust for 5 years assures that they will.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.