One of the more controversial, and sometimes brutal, aspects of this nation's system of caring for elderly people living in nursing homes is that these people must exhaust their life savings before they become eligible for financial assistance under Medicaid.

Until now, however, it has been possible for an elderly person to preserve some of his or her assets and still qualify for aid by putting the holdings into an irrevocable trust.

Last week, that loophole was plugged.

The Consolidated Budget Reconciliation Act of 1985, signed by President Reagan last Monday and effective two months from then, states that so long as the trustee (who can be the elderly person) has any discretion about how much money goes to the beneficiary -- also the elderly person -- who has applied for Medicaid, then the maximum amount allowed under the terms of the trust will be counted as assets or as income, whether or not it was actually received.

Since these trusts commonly allow the trustee to disburse as much as he or she sees fit, the elderly person is back where he or she started -- disqualified from Medicaid until the assets are gone.

The law is retroactive and will affect any existing trust, whether or not it was established for the purpose of evading rules in order to qualify for Medicaid.

Patients who have trusts and already are receiving Medicaid could suddenly be declared ineligible. If their spouse or children are receiving income from the trust and refuse to surrender the money, the patient could be evicted from the nursing home for not paying bills.

The law does, however, contain a hardship clause designed to avoid tragedies.

Charles Robert, a Hempstead, N.Y., lawyer and an advocate of these trusts,, attacked the new law as "short-sighted, despicable, bizarre policy. Now we will have to recommend that senior citizens give away their money."

Washington attorney Ron M. Landsman of Landsman & Laster says that under the new law the family of a patient could retain the assets if the trustee's discretion were abolished and the patient renounced all right to the income at least two years before applying for Medicaid.

Human nature being what it is, however, few people are likely to agree to place themselves at the mercy of others, lawyers say.

The new law extends a concept incorporated in the 1982 Tax Equity and Fiscal Responsibility Act that Medicaid has the right to recover for the cost of nursing home care. It can do so by imposing a lien on a person's assets and can punish those who dispose of their assets before applying for Medicaid in an attempt to get around the rules.

If an institutionalized person owns a house, for example, a lien can be placed on the property, and the state can collect from his estate after his death.

Federal law requires that exceptions be made in cases where a spouse or a disabled or minor child is still living there or where the person can reasonably be expected to return home.

However, if the patient gives the house to his children or other relatives within two years of applying for Medicaid, so as to eliminate assets that might otherwise be used to pay for care, the application will be denied.

The problem, of course, is money. Nursing home care costs at least $20,000 to $35,000 annually. And, according to a Harvard School of Public Health study that the House Aging Committee believes is representative of the country as a whole, two-thirds of nursing home residents go broke in three months; 90 percent face destitution after two years.

Although the average stay for all patients is 19 months, institutionalization for gradually degenerative diseases, such as Alzheimer's, can last many years.

Wealthy persons -- those with assets greater than $500,000 -- usually can afford institutionalization costs, and the state takes care of the indigent. So the rules fall hardest on the middle class.

Medicare, the federal health care program for the elderly and disabled, does not pay for nursing-home care. Nor does so-called Medigap insurance, private programs that supplement Medicare. Medicaid is the federal-state health care program for the poor. Very few insurance companies offer nursing home coverage, although in the past year several major carriers have undertaken pilot programs.

Patients are not eligible for any Medicaid coverage until they have "spent down" to the poverty level. The District and Maryland set that level at $2,500 in liquid assets, $1,500 in a burial account, a car worth no more than $4,500, an engagement ring and a home. In Virginia $1,700 in assets and a car are permitted. The home will be sold if the patient is not expected to return within three-to-six months, unless it is occupied by a spouse or dependent child.

The patient without a spouse is allowed $40 a month spending money in the District and Maryland, and $30 in Virginia. If there is a spouse at home who depends financially on the patient, the maximum income allowed is $325 monthly after deductions for medical and some other expenses. Any income greater than that amount must go toward the cost of care.

Facing institutionalization, a breadwinner may want to transfer or shield assets in order to provide for a spouse remaining in the home who has little or no other income. Other reasons include paying for grandchildren's college tuition or leaving the family business to one's children. An irrevocable trust -- one that did not qualify as assets or income for Medicaid purposes, and therefore could not be attached -- was one way of accomplishing these goals.

Lawyers say that most trusts are established by senior citizens at the urging of their children. While some people consider the objective noble, or at least clever, others consider it greedy and a way to cheat the government. A Capitol Hill aide put it this way, "Those who scream about welfare queens are often the ones who excel in tax avoidance."

No statistics exist on how many people have taken the advice of lawyers and accountants to establish trusts or how much Medicaid could hope to recoup, although the General Accounting Office has undertaken such a study.

The genesis of the new law was a 1985 article in Business Week magazine urging middle income people to establish carefully worded irrevocable trusts in order to qualify for Medicaid. This caught the attention of Rep. Henry A. Waxman (D-Calif.) who introduced an amendment to foil trusts.

"It is a terrible injustice to make people impoverished in order to get help," he said. "But it is also a great injustice to pretend to impoverish oneself to get aid."

Attorney Robert claims that eliminating trusts could foster even more hospitalization at greater costs to society. For example, if the institutionalized husband, who had been the provider, were obliged to use his money to pay for care, his wife, still living at home and without other resources, could be reduced to welfare. If she became sick, she would be unable to afford care outside an institution.

Spouses of institutionalized people have started to react by taking legal action. Painful as it is, some wives have sued their husbands for support, because such payments are out of the reach of Medicaid in some states. The Washington state Supreme Court recently upheld such a claim. Similar cases are occurring in New York. Attorney Landsman said he has some cases in this area where "spousal support may be an appropriate avenue to follow." Medicaid officials in Virginia say that state does not allow spousal support to be excluded from income.

So, while legislators believe they have closed the loophole and attorneys feel they may find other ways to prevent the loss of assets, both sides agree on one thing -- something further should be done.

"So long as Congress or the private insurance market doesn't provide a means of dealing with long-term care with some sense of dignity, then people will find a way," Landsman said. He suggested that some people would be willing to give up some acute care under Medicare in exchange for long-term care.

"I can understand the tragedy to families who have to make decisions [on who gets the money]. That's why we need catastrophic insurance," said Waxman. He praised the efforts of Health and Human Services Secretary Otis R. Bowen to devise such a plan.