By Stephen N. Wilchins, Scott A. Joseph and Brendan M. McGrory
When clients come into our office to discuss estate planning, they typically have two primary concerns: 1) maximizing the amount of wealth they are able to pass on to descendants and/or loved ones; and 2) minimizing the potential for disagreements and disputes among those descendants and loved ones. Both concerns are particularly relevant in the context of real estate, as often family homes hold sentimental value and are the most valuable asset in an estate, and families will want to avoid the sale of a home to pay for estate taxes or to settle a dispute over which child should have rights to a property. For many clients, these concerns can be addressed in advance by creating one or more Trusts designed to own the real estate, mitigate estate taxes, and ensure use of the real estate for the next generation.
One of the first questions we ask new clients is how their real estate is owned. When a person who owns a piece of real estate jointly with another person passes away, the decedent’s (the deceased person’s) interest in that property automatically passes to the surviving joint owner without court involvement. However, when a decedent owned a piece of real estate individually (i.e. not jointly with another person) at the time of death, the real estate must undergo the judicial process known as “probate,” before it can pass to his or her descendants and/or loved ones.
Probate is a time consuming, costly, and complex process that in many cases will require the decedent’s estate to hire an attorney. Depending on the nature of the decedent’s assets, the underlying dynamics of the decedent’s family, and the backlog of cases at the court, probate can be an emotionally draining and invasive process for those who have just lost a loved one and may take years to administer. The property that is a part of the decedent’s probate estate can only be distributed to his or her descendants and/ or loved ones as part of the probate process.
One option a client has for avoiding the probate of real estate is transferring the real estate to a Trust during his or her lifetime. A Trust is a legal entity which is formed pursuant to a Trust agreement between the person creating the Trust, the “Settlor” and the person administering the Trust, the “Trustee”. Once the Trust is established, the Settlor can transfer property to the Trust by recording of a deed, and the Trust will become the title owner of the property. Upon the Settlor’s death, the Trust, rather than the Settlor, individually, will continue to hold the property and, instead of undergoing probate, the property will be available for immediate use and enjoyment by the beneficiaries of the Trust (the Settlor’s descendants and/or loved ones).
Avoiding Family Disputes
The advantage of Trust ownership of real estate is not limited to the avoidance of probate. There are several types of Trusts and each type of Trust can be tailored to address a host of issues that may arise during the course of its administration. A basic revocable Trust will typically provide that any property owned by the Trust will be divided into shares for the beneficiaries and held for the benefit of such individuals by the Trustee or Trustees (who may be the beneficiaries themselves). In the case of real estate which does not hold particular sentimental value, this process often means liquidating the real estate and dividing the proceeds among the Trust shares for the beneficiaries.
The Trust, however, is also an excellent device for owning real estate that does have sentimental value or that the client wants to be used for a particular purpose. For instance, in the case of a family vacation home, a nominee Trust could provide a structure in which all descendants are able to use and enjoy the property, while also providing a mechanism for the payment of costs and expenses of maintaining the property by the descendants, such as real estate taxes and insurance. Further, in the event a client wants to ensure that a particular child has care and housing after the client has passed, a Trust can be drafted to ensure that a property is held in Trust for that child’s benefit and that Trust assets can be used for that child’s care, and could even be modified to ensure that the child remains eligible for government benefits.
Finally, a properly drafted Trust can provide asset protection in the event a descendant or loved ones who is a beneficiary experiences marital or creditor difficulties. Massachusetts case law provides that a Trust can be structured so that Trust assets will not be deemed part of the marital estate and subject to division in the case of a divorcing beneficiary. Moreover, the assets of a Trust which contains a properly drafted “spend-thrift” provision will be beyond the reach of creditors in the event creditors seek to attach those assets to a judgment. Please note that, as with all of the topics discussed in this article, you should discuss these topics in further detail with a professional before taking any action.
Avoiding Estate Tax
Many of our clients want to maximize the amount of wealth they are able to pass on to their children and loved ones, and are therefore happy to learn that American taxpayers currently enjoy the largest federal estate tax exemption ($11,700,000 per person in 2021) since the inception of the modern estate tax in 1916. As a result of this exemption, a taxpayer who dies in 2021 will be subject to federal estate tax only if the total value of the property he or she has gifted away during life and owns at the time of death exceeds $11,700,000. Clients are less pleased, however, when we explain that this increased federal exemption amount is scheduled to “sunset” on January 1, 2026, and return to $5,600,000 (adjusted for inflation) and, further, that President Biden and members of the Biden Administration (among others) have discussed tax reform that would reduce this number further (as low as $3,500,000 per person) and sooner (upon the enactment of such tax reform). Although it is difficult to speak generally in a federal estate tax environment that may change with a stroke of the President’s pen, there are basic techniques to reduce the estate tax impact of real estate ownership regardless of the value of the federal estate tax exemption.
One way a client can use a Trust to remove the value of real estate from his or her taxable estate is by transferring, or “gifting,” the real estate to a type of irrevocable trust known as an Intentionally Defective Grantor Trust (“IDGT”). Gifting real estate to an IDGT will effectively remove the value of the real estate and any future appreciation of the value from a client’s taxable estate. The result of the gift is that the Trust will own the real estate and the client’s remaining estate tax exemption will be reduced by the value of the real estate at the time of the gift. Although the client cannot serve as the Trustee of the IDGT, the client’s spouse or another trusted individual can be appointed to serve as the Trustee, and the client will be able to retain control over the real estate by retaining the right to remove and replace the Trustee.
A client may leverage his or her federal estate tax exemption more efficiently by gifting real estate to another type of irrevocable trust known as a “Qualified Personal Residence Trust” (“QPRT”). A QPRT is a trust to which a Settlor transfers his or her primary residence (or a vacation home which is not rented) and retains the right to live in the property for a period of years. The value of the gift of the property is calculated by reducing the fair market value of the property by the value of the interest in the property retained by the Settlor. This technique provides more leverage in a high interest rate environment, because the present value of the retained interest represents a larger portion of the value of the property, and therefore the value of the gift of a future interest in the property is smaller. It should be noted that a QPRT will fail and the entire value of the property included in the Settlor’s estate if the Settlor does not outlive the term of the QPRT and that these details should be discussed with an estate planning professional before being implemented.
This article briefly discusses only a few of the ways in which clients can use Trusts to create an estate plan that provides certainty with respect to mitigation of estate taxes and disputes among beneficiaries, while retaining the flexibility to address the future needs of beneficiaries. Contact us to discuss your particular situation and estate planning goals before creating a Trust.