Does Property in an Irrevocable Trust Qualify for both Medicaid Protection and Step-Up in Basis in New York?

I’m writing this in October of 2024. There’s been talk about last year’s IRS opinion that disqualified property in some irrevocable trusts from qualifying for a step-up basis after the decedent’s death. https://www.irs.gov/pub/irs-drop/rr-23-02.pdf.

In my opinion, it looks like property can still qualify for a step-up basis, as long as it’s includable in the decedent’s gross estate.

In order to avoid New York Medicaid estate recovery, the trust has to be Irrevocable. https://www.health.ny.gov/health_care/medicaid/publications/adm/11adm8.htm

Chapter 11 of the IRC lists all instances when property is included in the gross estate. https://www.law.cornell.edu/uscode/text/26/subtitle-B/chapter-11/subchapter-A/part-III.

In particular, 26 U.S. Code § 2036 - states that the following property is part of the gross estate: in which the decedent had the right of

(1)the possession or enjoyment of, or the right to the income from, the property (life estate), or

(2)the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

Looks like that’s life estate or power of appointment. And that it includes the entire property in the gross estate.

the value of the gross estate shall include the value of all property in which the decedent had a life estate, even if it’s in trust. This means that not only the value of the gross estate is included - the value of the entire property is included in the gross estate.

Under 26 U.S.C. § 2036(a), when a decedent has transferred property but retained a life estate—that is, the right to possess or enjoy the property or to receive income from it for life—the entire value of the property is included in the decedent's gross estate for estate tax purposes, not just the value of the retained life estate.

• General Rule of § 2036(a): The statute mandates that if a person transfers property but retains certain interests (like a life estate), the value of the transferred property is brought back into their gross estate upon death.
• Full Inclusion: The law is designed to prevent individuals from avoiding estate taxes by transferring property while retaining the benefits of ownership until death. As such, the full fair market value of the property at the time of death is included in the gross estate.
• Not Limited to Life Estate Value: The inclusion is not limited to the actuarial value of the life interest (the life estate) but encompasses the entire property's value. This means that the remainder interest (the value passing to the beneficiaries after the decedent's death) is also included.

If the decedent retained or reserved an interest or right with respect to all of the property transferred by him, the amount to be included in his gross estate under section 2036 is the value of the entire property, less only the value of any outstanding income interest which is not subject to the decedent's interest (26 CFR § 20.2036-1 (c)), in trust or otherwise (26 CFR § 20.2036-1(a))

Transfers with a retained life estate are includable in the gross estate:

Transfers with retained life estate (section 2036):

Section 2036 applies to the following retained interests or rights.

• The right to income from the transferred property.
• The right to the possession or enjoyment of the property.
• The right, either alone or with any person, to designate the persons who shall receive the income from, possess, or enjoy, the property.

This is a very sensitive area of the law. A small mistake can cost hundreds of thousands of dollars. Before drafting a trust, consult your attorney, and if you are an attorney, you can start with this article and the links above. If you're thinking about making a trust, you can give us a call at 212-233-1233 or send us an email at [email protected].

What "Step-Up in Basis" Means

The step-up in basis is a tax rule that resets the basis of inherited property to its fair market value at the date of the decedent's death (or the alternate valuation date six months later, in some cases). The rule has substantial practical importance:

• The original cost basis to the decedent (sometimes from decades earlier) is replaced.
• Heirs inherit the property with a new basis equal to the date-of-death fair market value.
• If heirs sell the property soon after death at or near the date-of-death value, little or no capital gains tax results.
• The capital gains that accrued during the decedent's lifetime are effectively eliminated.

For long-held appreciated property — like real estate purchased decades ago for modest sums — the step-up can save substantial capital gains tax.

The Carryover Basis Alternative

The step-up in basis at death contrasts with carryover basis applied to lifetime gifts:

• When property is given during life, the donee takes the donor's basis (carryover basis).
• When the donee later sells, the gain is calculated against the original donor's basis.
• The donee thus bears the tax burden on appreciation that occurred during the donor's ownership.

This contrast is why holding appreciated property until death (when step-up applies) is generally more tax-efficient than gifting during life (when carryover basis applies). The trade-off involves estate tax considerations — lifetime gifts can reduce estate tax exposure but at the cost of losing the step-up.

Property Includable in the Gross Estate

The step-up in basis applies to property included in the decedent's gross estate for federal estate tax purposes. Inclusion can occur through various provisions:

• Property owned outright at death (Section 2033).
• Property transferred during life but with retained life estate or income interest (Section 2036).
• Property transferred during life with retained right to alter, amend, or revoke (Section 2038).
• Property subject to a general power of appointment held by the decedent (Section 2041).
• Joint property to the extent of the decedent's contribution (Section 2040).
• Life insurance proceeds if the decedent owned the policy (Section 2042).
• Property transferred within three years of death in certain circumstances (Section 2035).

Whether a particular asset gets stepped-up basis depends on whether it is included in the gross estate under one of these provisions.

The Tension with Medicaid Planning

There is a fundamental tension between Medicaid asset protection and step-up in basis:

• Medicaid protection requires that the assets not be available to the Medicaid applicant. The assets must be irretrievably out of the applicant's control.
• Step-up in basis requires inclusion in the gross estate, which generally requires that the decedent had some retained interest or control.

These requirements seem to pull in opposite directions. The challenge in Medicaid planning is to structure trusts that remove assets from Medicaid consideration while preserving inclusion in the gross estate for basis step-up purposes.

Designing Trusts for Both Goals

Specific trust provisions can achieve both Medicaid protection and step-up in basis:

• Retained limited power of appointment. The grantor retains a special power to appoint trust assets among descendants, including the grantor's interest in the property for estate tax purposes without making the assets available for Medicaid.
• Retained income interest. The grantor receives income from the trust during life, causing inclusion under Section 2036.
• Retained right to use specific assets. Such as the right to live in a residence, causing inclusion of that asset.
• Grantor trust status for income tax. Combined with completed gift status for transfer tax purposes.

Designing these provisions requires careful coordination between estate planning and Medicaid planning rules. The provisions must accomplish their tax purposes without inadvertently making assets available for Medicaid.

Revenue Ruling 2023-2

Revenue Ruling 2023-2 addressed situations where assets in irrevocable grantor trusts that are completed gifts (so excluded from the gross estate for estate tax) do not receive a step-up in basis at the grantor's death. The ruling clarified what had been an area of uncertainty.

The implication is that simply being in a grantor trust is not sufficient for step-up — the assets must actually be included in the gross estate through one of the statutory inclusion provisions. Trusts structured to avoid estate tax inclusion will not produce step-up either, requiring care in planning.

The Alternate Valuation Date

For estates that file federal estate tax returns, the alternate valuation date provides an option to value assets six months after death rather than at death. The alternate valuation can:

• Reduce estate tax if asset values have declined.
• Establish a different (often lower) basis for the heirs.
• Help in volatile markets where date-of-death values were artificially high.

The election must be made on the estate tax return and applies to all assets in the estate (not selective application). The election is generally not available to estates that don't file estate tax returns.

Practical Examples

Examples illustrate the step-up principle:

Example 1: Parent bought a home in 1985 for $100,000. Home is worth $1,500,000 at death in 2024. Children inherit with basis of $1,500,000. If they sell shortly after death for $1,500,000, no capital gains. If parent had sold during life, parent would have owed capital gains on $1,400,000 of appreciation.

Example 2: Parent purchased stock for $50,000 over decades, now worth $400,000. Stock is gifted to children during parent's life. Children's basis is $50,000 (carryover). When children sell for $400,000, they owe capital gains on $350,000.

Example 3: Same facts but parent dies owning the stock. Stock is included in parent's estate. Children inherit with basis of $400,000. Sale at $400,000 produces no capital gains.