How a Medicaid Asset Protection Trust Affects Your Capital Gains Taxes

A Medicaid Asset Protection Trust is an irrevocable trust used to move a home out of your own name so that it is not counted against you if you later need Medicaid to pay for long-term care. Most of the discussion around these trusts centers on eligibility and protection from Medicaid liens and estate recovery, but the way the trust is drafted also determines what your children will owe in capital gains taxes when the property is eventually sold.

How the trust holds your home

Once the deed is transferred, the trustee, usually an adult child, holds legal title, and the terms of the trust keep you from reaching the principal. You retain the right to live in the home for life and usually to receive any income the trust produces. Because the principal is beyond your reach, the house stops being a countable resource once the lookback has run, which for nursing home coverage means the sixty months preceding the application. As we discussed in a prior article on the lookback, a house should move into trust well before care is needed.

Basis, not value, drives the tax bill

A capital gain is the difference between what a property sells for and its basis, which for most homeowners is the purchase price plus capital improvements. When you hand a deed to a child during your lifetime, the child takes your basis along with the property. When the same property passes at death, the basis resets to the fair market value on the date of death. A Queens homeowner who paid $90,000 in 1988 for a house now worth $950,000 is carrying roughly $860,000 of built-in gain. Deeded outright to a daughter today, that gain follows the house, and when she sells she reports all of it: federal capital gains tax at fifteen or twenty percent, the 3.8 percent net investment income tax, New York State income tax, which treats capital gain as ordinary income, and city income tax on top of that. If the same house passes through a properly drafted trust, the basis resets to the date-of-death value, and a sale shortly afterward produces little or no taxable gain.

Why the trust preserves the step-up in basis

The step-up survives because the trust is written so the house remains part of your taxable estate. That is accomplished by retaining the right to use the property for life and by reserving a limited power of appointment that lets you redirect the remainder among a defined class of family members. Those retained rights pull the property back into the gross estate, which is what produces the new basis, while the principal stays out of your hands for Medicaid purposes. Inclusion costs the average family nothing, since the federal exemption is $15 million per person in 2026 and New York's is $7.35 million. That is why I advise clients never to sign a deed over to a child at the kitchen table. A direct gift can meet the Medicaid goal but still leave a tax bill for the children that the trust would have avoided.

Selling the house while you are living

A trust drafted this way is a grantor trust for income tax purposes, meaning the IRS looks through it during your lifetime. Interest, dividends, and capital gains are reported on your own return under your own Social Security number and taxed at individual rates rather than the compressed trust brackets. Grantor status also preserves the home sale exclusion. If you used the house as your principal residence for two of the five years before the sale, you may still exclude $250,000 of gain, or $500,000 if you are married and file jointly, even though the trust holds record title. A trust that fails to qualify gives up that exclusion, which is one reason these documents should not be pulled from a form. One practical point on a lifetime sale: the proceeds from the sale must be deposited into a trust account rather than your own, or they become a countable resource and undo the protection you waited five years to build.

Assets other than the house

The same treatment follows brokerage accounts, certificates of deposit, and other investments held in the trust. Dividends and realized gains appear on your personal return. Also, a lifetime sale of appreciated assets generates a capital tax bill while the same holding kept until death receives a new basis. Your STAR and senior exemptions remain available, since you have kept the right to live in the house for life.

What this means in practice

I recommend the MAPT option to homeowners who want the house protected and do not expect to sell it during their lifetime. The trust does the Medicaid work while leaving the family in the same tax position they would have been in had nothing been done.

If you are considering a Medicaid Asset Protection Trust for your home and want the capital gains side handled correctly, contact us today at (347) 766-2685 for a free phone consultation.

Contributed by Roman Aminov, Esq, a Queens estate attorney in New York City.