They Moved the House Into a Medicaid Trust in 2017 and Everyone Told Them the Kids Would Lose the Step-Up. Mom Died in March, the Kids Sold in May, and the IRS’s Share of 38 Years of Gain Was $0

If your parents moved their house into a Medicaid trust, someone has probably told you the move cost you the step-up in basis. The good news is that warning is frequently wrong. Instead, a properly written Medicaid asset protection trust keeps the home out of a nursing-home spend-down and still leaves you with a fresh basis set at the date of death. When someone sells the home, the capital gains tax on decades of appreciation can drop to zero.

Try to picture a family that is in this scenario who bought the house about 38 years ago and moved it into the trust in 2017. Unfortunately, the Mom died in March, so the kids sold in May, and the gain the IRS could tax covered only those two months.

Why a Medicaid Trust Can Keep the Step-Up a Gift Throws Away

Most of the confusion starts with gift rules. When a parent transfers a house straight to a child, the child keeps the parent’s original basis under 26 U.S.C. § 1015(a), so every dollar of gain since the purchase stays taxable. A Medicaid trust looks like a gift, and people assume the same result follows.

The outcome turns on what the parent keeps, as many Medicaid trusts let the grantor live in the home for life. That retained right brings the house back into the parent’s taxable estate at death, and the property gets a new basis equal to its fair market value on the date of death. Medicaid treats the house as protected, while the IRS treats it as the parent’s at death.

Code Sections That Back It Up

For anyone in this situation, it’s important to know that there are three provisions that do the work. Under 26 U.S.C. § 2036(a)(1), the gross estate includes transferred property when the grantor kept, for life, the possession or enjoyment of the property or the right to its income. 26 U.S.C. § 1014(b)(9) then treats property that must be included in the gross estate as acquired from the decedent. Section 1014(a)(1) sets that property’s basis at fair market value at the date of the decedent’s death.

The IRS has also spelled out the reverse case. In Rev. Rul. 2023-2, it concluded that no step-up in basis is available for assets in an irrevocable grantor trust that are not included in the grantor’s gross estate. Estate inclusion is the deciding factor. IRS Publication 550 also confirms that gain on inherited property is considered long-term, regardless of how long you held the property.

Who Gets the Fresh Basis and Who Misses Out

You qualify if the trust gave your parent a retained life interest or another power that puts the house in the taxable estate. Elder-law attorneys describe this as the grantor retaining certain powers, which causes the trust assets to be included in the grantor’s taxable estate.

You miss out if your parent gave the house directly, or if the trust was written to remove the house from the estate entirely. Most families pay no estate tax for the inclusion. Those who die in 2026 have a basic exclusion of $15,000,000.

How to Claim the Step-Up Before You Sell

1. Have a trust lawyer read the trust document and confirm the retained occupancy right or power that causes estate inclusion.
2. Order a professional appraisal as of the date of death. If the estate filed Form 706 and you received Schedule A (Form 8971), use the final estate tax value of the property reported on Schedule A.
3. Sell while the appraisal still reflects the market. Only appreciation after death is taxable, and selling costs reduce your gain. A May sale near the March appraised value leaves little or nothing to tax.
4. Report the sale as long-term on the trust’s return or your own, depending on whether the trust sold the house or distributed it to you first.

The dollars at stake can be large. The Case-Shiller national home price index rose from 184.627 in January 2017 to 337.306 in July 2026, a rise of about 82.7%. The step-up wipes out that gain, plus everything built up before the trust was.

Written Mistake That Erases the Benefit

The biggest catch sits in the trust document itself. Some attorneys wrote Medicaid trusts to keep assets out of the estate on purpose, and under Rev. Rul. 2023-2 those heirs get no step-up. If your parent is still alive, have the trust reviewed now, while there’s still time to fix the language.

Medicaid’s look-back adds a second trap. Federal law requires a 60-month (5-year) look-back, and transfers inside that window can trigger a penalty period. The 2017 family passed it years ago. A parent who funds a trust today and needs care in three years would not.

Timing also matters because the basis locks at the date-of-death value, so a rising market between death and closing creates taxable gain, while a falling one can produce a loss. Get the appraisal early, keep it with your records, and treat the trust document as the item that decides whether this step-up was at all.

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