by Dyches Boddiford
Trusts have been used as an entity to hold assets, such as real estate for hundreds, if not thousands, of years. Obviously, it’s old stuff. But, with each generation’s trials and tribulations, trusts evolve to meet new challenges. High Taxes and aggressive litigation are today’s motivators. Tax risks range from income tax to draconian death taxes that consume up to 55% of the assets a person leaves behind. Trusts are often used along with more modern adaptations of other old entities, such as partnership aberrations, to include family limited partnerships and limited liability companies. The quest is to keep what you have accumulated and to have some extended control of it, even after death.
A perfect example of using ingenuity to keep one’s assets away from the grips of the tax man was a trust established by Maria Cristofani in 1984. Maria established a trust and transferred to it real estate with a value of $70,000. The primary beneficiaries were her two children and, as contingent beneficiaries, 5 grandchildren should the two primary beneficiaries die within 120 days of Maria. All was fine until Maria died and the IRS audited her estate tax return.
Naturally, the IRS wanted more money. They claimed that Maria failed to file a gift tax return and owed back gift taxes. The IRS argued that Maria was entitled to give $10,000 per year to the two primary beneficiaries, but that taxes were owed on the $50,000 not excluded. The estate disagreed, claiming that the 5 contingent beneficiaries did have an interest in the trust. The trust had a Crummey power and, in accordance with that power, the trustee had given written notice to all 7 beneficiaries of their right to withdraw. Thus, the full $70,000 was excludable.
This means that multiple-beneficiary trusts now can be used to expand the fit-tax exclusion. It took someone with a tolerance for risk to mix old law, and an old trust entity with a new way of looking at the old to save Maria’s family substantial wealth. Over the years trusts have been used extensively in the attempt to control how much the government inherits. Some of the more familiar trust names include: Bypass Trust; Marital Deduction Trust; Generation Skipping Trust; Grantor Retained Income Trust; Insurance Trust; etc. The common thread for all of these trusts is to legally avoid paying the majority of the deceased’s wealth to the government. Failure to act is to assure that the estate will pay the highest possible tax.
A Need For Privacy
Real Estate Investors often use trusts as business devices. It is hard persons never being in business to understand, but business can be war. There is an ever growing number of enemy soldiers attempting to invade and plunder the investor’s castle of wealth. Sometimes this is accomplished by out and out illegal means, such as thieves that rob and destroy property or those who embezzle by not paying rent. The cruelest enemy is he who uses the law to plunder. Today, lawsuits are treated as a lottery.
Enemy troops look for excuses to sue; it is nearly a guaranteed profit. If a person can find some excuse to sue, even if very flimsy, the defendant will almost always settle for at least a few thousand dollars because it is cheaper to settle than to incur the cost of legal defense. It has become so bad that in some cities, such as Buffalo, NY, unscrupulous people publish lists of landlords and divulge such things as the number of properties, the number of units and the total value of real estate owned. Why? Because contingency fee lawyers will not spend the time and money to go after someone with minimum assets. They look for the ‘fatted lamb’.
Land Trusts
A result of this attack is a defense system. Trusts are used by some investors as a key part of their defense. The most common trust used in real estate investing is referred to as an Illinois style land trust. The primary purpose is to remove the legal title from the investor’s name. The title is held in the name of a trustee and the investor is both the grantor and the beneficiary to the trust. the trust does not offer the same kinds of protection a corporation or limited liability company can, but it has a place in the castle’s defense and is the most economical of all entities to set up and maintain.
Legal advisors often recommend trusts be used in conjunction with other business entities assuming the amount of wealth involved is sufficient to justify the cost of the business entity. Trusts, on the other hand, are usually very economical. An attorney prepares the original trust and it can be duplicated for additional use. The fee to have a knowledgeable attorney prepare a land trust can range from $300 to $1,000. Some of us do our own trusts, but a great deal of knowledge must be obtained before you consider doing this. There are no additional expenses, such as franchise fees or income tax returns. A land trust is reported on the beneficiary’s tax return as if the beneficiary personally owned the property.
Other Trusts
There are numerous possibilities for the name given to a trust. Such names are often chosen to reflect the primary function of the trust:
Education Trust;
Wealth Replacement Trust;
Charitable Remainder Trust;
Spendthrift Dynasty Trust,
etc.
Since names are assigned to trusts the public can get the wrong impression. It is often assumed that a named trust is like any other consumer good, such as the name ‘car’ or ‘truck’. A person wants to buy, say, a car but not a truck. They want a Spendthrift, but not an Education Trust. Actually all trusts are just trusts. The primary thing that differentiates them are clauses written into the trusts. For example, a single clause will turn an education trust into a spendthrift education trust.
The point is not to let names become confusing. The fundamentals of trusts are simple to comprehend. First, all trusts are either inter vivos or Testamentary. Inter vivos trusts are set up while the grantor is alive and are often referred to as a ‘living trust’. The testamentary trust, on the other hand, is set up after the person’s death by authority written in the deceased’s will. All trusts will be either an inter vivos or a testamentary trust.
Revocable & Irrevocable Trusts
Inter vivos trusts are either revocable or irrevocable. Revocable means the grantor can either revoke the trust or else maintain some significant power to maintain control of the trustee or use of the trust assets. Irrevocable means the grantor totally gives up rights and powers and walks away entrusting to the trustee all of the assets in the trust, referred to as the ‘corpus’.
The government treats most inter vivos revocable trusts as grantor trusts. As previously mentioned, grantor trusts are reported on the grantor’s tax return. Irrevocable trusts have more complex tax returns. in a nut shell, they are either a simple trust or a complex trust for tax reporting purposes. These returns are best prepared by professionals.
Most investors will be dealing with inter vivos or living trusts. Trusts used to hold operational real estate will generally be revocable, grantor trusts. These trusts are more for operational purposes that estate tax planning purposes. In general irrevocable trusts will be used to deal with estate tax planning.
Depending on the client’s objective, the attorney will draft a base trust to emphasize certain objectives, such as children’s education , or a land trust. Examples would be an education trust that is an irrevocable inter vivos trust and the land trust that is a revocable inter vivos trust.
Common Characteristics
Some common characteristics of the living trust are:
Assignment - In certain cases trusts can be assigned to third parties without changing the public records. Thought we do not recommend it, some real estate investors have used this feature in dealing with due on sale clauses of mortgage contracts.
Assurance - The trust may provide greater assurance that the grantor’s wishes will be met. Wills are more easily contested by disgruntled heirs and “want to be” heirs.
Avoids Guardianship of the Assets - Using a Trust the grantor/beneficiary has greater assurance that his assets will be managed in a manner prescribed by him and will be spent as he instructs in the trust document. If a trust does not exist and a guardian is appointed by the courts, then the courts and guardian make these decisions with no input from the incapacitated party. A guardianship is more expensive to administer than a trust since the Court usually requires a periodic accounting by the guardian.
Incapacitation of Trustee - If the owner of the property becomes incapacitated, managing assets can become a problem. A trust allows for an alternate trustee to step into the shoes of an incapacitated trustee without affecting management of the property.
Limited Liability - There is no significant liability protection. At best, the trust provides greater privacy as to who is the beneficiary. In most states living trusts are treated as the alter ego of the grantor. As such, liability may be attributed to the grantor.
Privacy At Death - Ownership transferred upon the death of the grantor/beneficiary of a trust is private when contingent beneficiaries are listed. Unlike a will, which is probated, a trust document does not become public record. Land trusts typically do not have contingent beneficiaries and, therefore, any property held in the trust would simply be included in the deceased’s probated estate.
Privacy While Living - Some real estate investors wisely seek privacy regarding the ownership of their real estate. They do not want their name as the owner of the public property records which would allow anyone to know how much wealth they owned in real estate and where that real estate is located. It can also cause a serious operational problem. For example, a judgment against the investor even for a small amount would give the judgment holder immense leverage diminishing the investor’s opportunity to negotiate a lower settlement on the judgment. The judgment attaches to all of the investor’s real estate. This would prohibit the investor from selling any real estate without first paying the judgment in full.
Probate - Where a trust has contingent beneficiaries listed, costs associated with probate are avoided since the trust is not probated at death.
Taxes (Income) - There is no tax benefit. The tax information is reported on the grantor’s personal tax return.
Taxes (Estate) - The Irrevocable trust, Insurance trust, Bypass trust and Marital Deduction trust are the most common trusts used to save estate taxes. Note that an irrevocable trust is a book trust and can be used for many purposes, such as the trust names indicate, Charitable Remainder Trust and Spendthrift Dynasty Trust. The revocable land trust saves no estate taxes.