A new IRS ruling could affect your children’s inheritance
In a major shift, a new IRS ruling has tightened the regulations surrounding irrevocable trusts and the step-up basis.
In the past, families have been utilizing irrevocable trusts to protect their assets from spend-down to still qualify for benefits like Medicaid and VA Aid. Also during this time, it was not clear if assets passing to beneficiaries through an irrevocable trust would receive a step-up in basis, which eliminated any capital gains taxes that would otherwise be owed.
Historically, assets that individuals sold or transferred during their lifetime have been taxed as capital gains, based on the appreciation in value that occurred over time. The capital gains owed are predominantly calculated by comparing the asset's value at the time of purchase with its value at the time of transfer.
An exception to the obligation of capital gains taxes comes when the owner of the assets dies, and the assets pass to their beneficiaries. The beneficiaries receive a step-up in basis, therefore they inherit the assets as if it had been purchased at the current fair market value instead of the value of the assets at the original time of purchase. This eliminates any capital gains, and no taxes become due.
The new IRS ruling has tightened the regulations surrounding irrevocable trusts and the step-up in basis. According to the updated guidelines, assets held within certain irrevocable trusts will no longer receive the benefit of a step-up in basis upon the grantor's death. Instead, the assets will retain their original basis, potentially leading to higher capital gains taxes when beneficiaries decide to sell them.
You may be wondering why anyone would do irrevocable trust planning in the first place since it sounds like it will be subjecting your children to additional taxes, and it’s often because many Americans are living longer and are finding they need long-term care, which on average can cost $6,500 to $10,000 per month.
There are not many families who can afford to pay that out of pocket without depleting their life savings. That means many are turning to programs like Medicaid and VA Aid and Attendance to help with the cost. To be able to qualify for these programs, you will be expected to spend-down your assets to a level set by the state where you live. An irrevocable trust is one of the only tools that can protect assets from being subject to the spend-down process.
The IRS ruling focuses on a crucial aspect: the assets held within an irrevocable trust that are not already considered part of your estate for estate tax purposes will no longer receive the step-up in basis benefit. Therefore, if you create an irrevocable trust that is not structured appropriately, the step-up in basis privilege will be forfeit. This move seems to be aimed at broadening the scope of estates subject to estate taxes, urging individuals to establish properly structured irrevocable trusts to retain the step-up in basis advantage.
When the value of the home is included in the estate, many families will find that they are not subject to estate tax because the current federal estate tax only applies to estates valued at $12.92 million or more. However, that could change in 2026 when the estate tax limit is lowered to half that amount.
The new IRS ruling on irrevocable trusts and the step-up basis marks a notable shift in tax planning and estate management, so it’s essential to have the right team around you when planning.
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