Moving real estate into a Special Needs Trust can protect a loved one’s long-term future and government benefits, but it can also create costly capital-gains tax issues or expand Medicaid’s right to reimbursement. The difference often comes down to timing and trust design.

These three questions can help you navigate this complex decision and help you avoid costly mistakes:

Question 1) Is it a First Party SNT or a Third Party SNT?

Before you transfer a house into a Special Needs Trust (SNT), the first consideration is whether it is a First Party SNT or a Third Party SNT.

Funding a Third Party Special Needs Trust with real estate is a common and powerful strategy. A Third Party SNT is a strong vehicle for holding real estate because there is no Medicaid Payback. That means when the person with special needs passes away, any property still in the trust, like a house, can go to other family members or heirs, helping to grow generational wealth.

On the other hand, placing real estate into a First Party SNT is usually a bad idea. A First Party SNT is required to pay back the State for the cost of Medicaid services after the beneficiary’s death. That could lead to the property being sold to repay the government.

Question 2) Will the Transfer Occur Before or After Death?

When adding real estate to an SNT, it’s important to consider the timing of the transfer because of the capital gains tax rules. Properly timing the transfer of real estate into a Third Party SNT can greatly minimize and even eliminate the capital gains tax.

What is Capital Gains Tax?

Capital gains tax is charged when you sell an asset, like real estate, for more than you paid for it. The profit, called a gain, is what gets taxed. The gain is the difference between the sale price and the original purchase price. The original purchase price is known as the basis. (If you made improvements to the property, the basis may be adjusted to include those costs.)

Why Timing Matters

How the IRS treats capital gains depends on when the property is transferred. A testamentary transfer, which is made at death, is treated more favorably than an inter vivos transfer, which is made during life. (Inter vivos means “between the living.)

• For an inter vivos transfer: the original basis carries over to the new owner

• For a testamentary transfer: the new owner takes a basis step up to the fair market value at the time of death.

  
  

Example:

Nancy bought a house many years ago for $100,000. That value is her basis. Today, the house is worth $400,000. Let’s compare an inter vivos transfer and a testamentary transfer of Nancy’s house into an SNT.

Option (A): Transfer During Life

Nancy transfers the house into a Third Party SNT while she’s still alive. This is an inter vivos transfer, so the original basis carries over to the trust. This means, the trust owns the house with the original $100,000 basis. Later, the SNT needs to sell the house and sells it for its fair market value of $400,000.

Result: The SNT owes capital gains tax on $300,000.

($400,000 sales price - $100,000 basis = $300,000 in taxable gain)

Option (B): Transfer at Death

Nancy transfers the house to the SNT at her death through her will. This is a testamentary transfer, so the new owner takes a basis step up. On the date of Nancy’s death, the house is worth $400,000. Because of the step up in basis, the trust owns the house with a stepped-up basis of $400,000. The original basis $100,000 is “stepped up” to $400,000. The Trust needs to sell the house and sells the house for its fair market value of $400,000.

Result: $0 in capital gains tax.

($400,000 sales price - $400,000 stepped-up basis = $0 in taxable gain)

Even if the Trust doesn’t sell the property right away, the step up in basis offers major tax savings if and whenever a future sale does happen. This helps preserve more money in the Trust for the person with special needs.

When an Inter Vivos Transfer Might Make Sense

In most situations, it’s better to transfer real estate to a Third Party SNT after death to avoid capital gains tax.

However, in some cases, such as with high-net-worth families, it might make sense to transfer the property during life. This strategy can help reduce exposure to federal estate taxes, which apply when an estate is worth more than $13.99 million. In those situations, reducing estate taxes may be more important than avoiding capital gains.

Question 3: Is the Real Estate Mortgaged or Paid Off?

Families often ask if they can transfer real estate with a mortgage (such as a home loan) into a Third Party SNT. The main concern is whether the lender (like a bank or credit union) could force the loan to be paid off right away because of a due-on-sale clause in the mortgage agreement.

A due-on-sale clause gives a lender the right to demand full payment of the mortgage if the property is transferred to someone else (or transferred to a trust). This can be a problem when trying to move a house into a trust.

There is a federal law, the Garn-St. Germain Act, that protects homeowners from the due-on-sale clause, but only in certain cases. When it comes to Third Party SNTs, the law is unsettled. The law is not expressly clear whether a lender may demand full repayment of the mortgage when the property is moved into an SNT. Due to this grey area of the law, it would be wise to take extra precautions.

If a parent wishes to use a mortgaged house to fund a Third Party SNT, one strategy is to purchase a life insurance policy that can be used to pay off the mortgage when the parent dies. That way the mortgage can be paid off, the house can be transferred to the SNT, and there are no delays or risk of foreclosure with the lender.

Conclusion

Using real estate to fund a third-party special needs trust can be an effective and meaningful strategy by offering a way to provide long-term support, housing, and financial security for a special-needs beneficiary while preserving their eligibility for government benefits. However, it introduces complexity.

If you are considering this route, the best practice is to consult a special needs trust attorney, who can help you draft the required trust language and decide whether an inter vivos or testamentary transfer is more appropriate.

Every family wants to know that their loved one will be protected no matter what the future holds. With smart planning and the careful use of real estate within a third party special needs trust, you can build a legacy of security, comfort, and continued support. We are committed to walking with you through each step, ensuring your plan reflects both your values and your vision for your loved one’s future.