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Your instincts are right that there could be some very big issues with these transactions. If your mother-in-law is qualified for Medicaid now then her home is not counted as an asset to determine her eligibility. If she sells her home the cash will be counted against her eligibility. She can only have $2,000 in countable assets to be eligible for Medicaid.
There are also issues with her using her money to build an addition on to your home. Even though this addition will be used for her it is still improving your property. Medicaid will likely look at this as a gift. I am not worried about taxes because Pennsylvania does not have a gift tax and the federal gift tax exemption is 5.125 million dollars. Your mother-in-law would have to give your wife more than 5.125 million dollars before your wife has to pay gift tax.
However, if your mother-in-law writes your wife checks then Medicaid will certainly view those transfers as a gift and every time that she gives her money it will cause your mother-in-law to essentially be ineligible for Medicaid benefits for 5 years. If your mother-in-law pays the contractors directly that may get around the deeming of a gift by Medicaid. The answer to the question of whether it will be okay depends on the Medicaid caseworkers in your area. To completely prevent it from being a gift you could sell a portion of your home to her based on the amount of money that she will be paying for the addition.
I would highly suggest getting full advise from an Elder Law attorney in your area. I am sure that they will be able to clarify these options, plus maybe give you others based on the full facts of your situation. You can find an attorney at http://www.naela.org/.
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