They Moved the House Into a Medicaid Trust in 2017 and Everyone Told Them the Kids Would Lose the Step-Up. When Mom Dies and the Kids Sell, the IRS’s Share of 38 Years of Gain Will Be $0

If your parents moved the family home into an irrevocable Medicaid trust, someone probably told you the kids lost the step-up in basis. In many cases, a properly drafted Medicaid asset protection trust preserves the step-up. The house passes with a basis equal to its value on the date of death, so a home bought decades ago and sold soon after Mom dies can produce zero taxable gain. Whether your family gets that result depends on a few lines of trust language that many families never check.

Why a Medicaid Trust Can Still Deliver a Step-Up

Most Medicaid trusts are written as income-only trusts. The parent gives up access to the principal, which Medicaid looks at, but keeps the right to live in the house for life. That retained right brings the home back into the parent’s gross estate, where it becomes subject to the estate tax. Once the home is in the estate, it qualifies for a new basis at death. The years of appreciation from the original purchase price to the date-of-death value drop out of the capital gains calculation.

Code Sections Behind the $0 Tax Bill

Under 26 U.S.C. § 2036(a)(1), the gross estate includes certain property. This is property the decedent transferred “by trust or otherwise” while keeping “the possession or enjoyment of, or the right to the income from, the property” for life. Section 1014 then treats property “required to be included in determining the value of the decedent’s gross estate” as acquired from the decedent under § 1014(b)(9). Under § 1014(a)(1), the basis becomes “the fair market value of the property at the date of the decedent’s death.” IRS Publication 523 applies the same rule to inherited homes and points readers to section 1014.

Including the house in the estate rarely triggers estate tax for a typical family. The basic exclusion amount is $15,000,000 under § 2010(c)(3)(A), set by recent legislation, with inflation adjustments starting for deaths in calendar years after 2026.

Which Trusts Qualify and Which Do Not

The rule helps beneficiaries of an irrevocable trust in which the parent kept a lifetime right to occupy the home or receive its income. Many Medicaid trusts also give the parent the power to change who ends up with the property. That power separately triggers estate inclusion under § 2036(a)(2), which covers the right “to designate the persons who shall possess or enjoy the property.”

Trusts where the parent kept no interest at all are not subject to the rule. In Revenue Ruling 2023-2, issued March 30, 2023, the IRS concluded that completed gifts to an irrevocable grantor trust that stay out of the gross estate get no step-up at death. The children then inherit the parent’s original basis.

Steps to Lock In the Stepped-Up Basis

1. Pull the trust document now and find the retained-interest language: a lifetime right of occupancy, a right to income, or a limited power of appointment. Ask the drafting attorney to confirm the trust was built to be included in the estate.
2. After death, order a qualified date-of-death appraisal. If no Form 706 was required, Publication 523 sets your basis at the home’s appraised value at the date of death.
3. If the executor files Form 706 and sends you Schedule A (Form 8971), use the final estate tax value reported there as your basis.
4. Sell and report the sale. Gain on inherited property is long-term, regardless of how long you held it. A sale at the appraised value produces no taxable gain.

Where Families Lose the Step-Up Without Realizing It

The biggest risk is in the drafting. A trust written only for Medicaid purposes, with no retained interest, protects the house from nursing home costs but sends it to the kids at the parent’s original basis. Families who set up their trust before Revenue Ruling 2023-2 often never had the document reviewed with that ruling in mind.

Timing also matters, as the step-up covers only what the trust holds at death, so if the trustee sells the house while the parent is alive, any gain is realized at that point. A sale after death for more than the appraised value also creates taxable gain on the difference.

Medicaid’s transfer review is a separate test from the tax rules: in most states, it uses a 5-year (60-month) look-back on asset transfers. A trust funded in 2017 meets both sets of rules only if the parent kept a retained interest strong enough for estate inclusion but no access to principal that Medicaid would count.

Families with an existing trust can have an elder law or estate attorney review the document now, while the parent is still alive, so they can address any problems. These issues usually trace back to a missed clause, an outdated beneficiary, or an untitled account, and we put the full cleanup checklist in a free guide.

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