Buying/Owning Homes for Trust Beneficiaries: Legal, Tax and

March 2, 2016

Buying/Owning Homes for Trust

Beneficiaries: Legal, Tax and

Practical Considerations

○ There are three basic ways that a home can be acquired

for a trust beneficiary.

− The trust buys the home and allows the beneficiary to live

in the house rent free.

− The trust lends the money to the beneficiary who then

acquires the home in his or her own name.

− The trust makes a distribution of funds in accordance with

the trust’s distribution provisions, and the beneficiary then

acquires the home in his or her own name.

Introduction

○ Deemed Distributions to Beneficiary Living in Home Held

by Trust

− Rent free use of the home should not be treated as a

distribution to the beneficiary.

− Payment of ordinary and necessary maintenance expenses

of the home probably won’t be treated as a distribution to

the beneficiary.

− Payments of other expenses that are more personal to the

beneficiary rather than the maintenance of a capital asset

of the trust (e.g., utilities) could be treated as a

distribution to the beneficiary.

Income Tax Issues

○ Deduction of Interest and Expenses

− Mortgage interest should generally be deductible by the trust,

subject to the limitations that would apply to beneficiary-owned

property.

− Property taxes should generally be deductible by the trust.

− Expenses required to preserve the home as a trust asset

arguably could be deductible by the trust, but also may be

viewed as nondeductible personal expenses.

− Expenses that are more personal to the beneficiary (e.g.,

utilities and other expenses of the beneficiary’s occupancy)

presumably would not be deductible to the trust, except

possibly as a distribution to the beneficiary.

Income Tax Issues

○ Capital Gains

− Sale of the home by the trust will generate a capital gain

(assuming, of course, it has appreciated).

− Sale of the home by a beneficiary would also generate a

capital gain, but that gain might qualify for the

$250,000/$500,000 exclusion for gain on the sale of a

principal residence.

Income Tax Issues

○ Deemed Distributions to Beneficiary Who Purchases

Residence with a Loan from Trust

− If the Trust loans money to the beneficiary so that he or she

may purchase a house, and the beneficiary fails to repay the

loan, the following may result:

○ A deemed distribution to the beneficiary if the trustee would

otherwise have the ability to collect but does not actively pursue

repayment.

○ A deemed distribution if the trustee applies amounts that would

have been distributed to the beneficiary to satisfy the debt.

○ Cancellation of Debt Income to the beneficiary if the trustee

determines that the loan is uncollectable and forgives the loan.

Income Tax Issues

○ The fiduciary duties of the trustee should not be ignored

in structuring the ownership of the home.

○ If the home is to be acquired by the trust, it must

represent a reasonable investment of the trust

considering all the usual factors under state law and the

trust agreement.

− The trust agreement will govern whether and to what

extent a trustee may allow a beneficiary of the Trust to live

in a house held by the Trust rent free and to what extent

the Trust is allowed to loan money to a beneficiary in order

to buy a home.

Fiduciary Duties of the Trustee

− Texas Trust Code, which defines the default rules if the

trust agreement is silent, allows the trustee to:

○ Permit real estate held in the trust to be occupied by a

beneficiary who is currently eligible to receive distributions.

Texas Trust Code 113.022(1).

○ If reasonably necessary for the maintenance of a beneficiary

who is currently eligible to receive trust distributions, invest

in real property to be used for a home by the beneficiary.

Texas Trust Code 113.022(2).

Fiduciary Duties of the Trustee

− If the beneficiary will not be paying rent, this should be

considered as part of the overall appropriateness of the

investment as this will obviously affect the trust’s return

on the investment.

− Diversification issues should be considered. Section

117.005 of the Texas Trust Code provides that the trustee

shall diversify unless the trustee reasonably determines

that, because of special circumstances, the purposes of

the trust are better served without diversifying. Modern

trust agreements often attempt to abrogate the duty to

diversify, but the duty should never be ignored.

Fiduciary Duties of the Trustee

○ If the trustee lends the money to the beneficiary, the

loan must be on appropriate terms with adequate

security for the trust.

− When the trust instrument permits discretionary principal

distributions to the beneficiary, the Restatement gives

considerable flexibility in this area. Under the Third

Restatement, a loan is treated as a form of discretionary

benefit, and may be made at a market rate of interest or at

low or no interest; and funds may even be advanced with

recourse only against the beneficiary's interest in the trust,

without personal liability. See RST (THIRD) § 50 comment

(d)(6).

Fiduciary Duties of the Trustee

− The loan will be part of the trust’s overall investment portfolio and

therefore should be appropriate as an investment under the trust

agreement and state law.

− If the loan structure is employed, be sure that all parties understand

that this is a real loan and that the trustee may have to foreclose on

the property if the beneficiary fails to make payments. Failure to

aggressively pursue such a debt could have fiduciary concerns for the

trustee and income tax issues for the beneficiary.

− To this end, consider whether the trustee wishes to perfect the

security interest by filing appropriate UCC statements. Such

perfection is not necessary to make a valid debt, but there are

certainly times when beneficiaries may have other creditor issues, and

perfecting the security interest may become important.

Fiduciary Duties of the Trustee

○ If the trustee makes a distribution to the beneficiary to

purchase the home, the distribution must be proper under

the trust agreement’s standard for distributions and

applicable state law.

○ Distributions for the purpose of acquiring a home under the

typical health, education, maintenance, and support standard

are generally considered appropriate as long as the

distributions and purchase are consistent with the

beneficiary’s accustomed standard of living. Query whether

a beneficiary is entitled to a larger home as he advances in

age.

Fiduciary Duties of the Trustee

○ Transfer Tax Consequences of Trust Ownership

− If the trust owns the house and allows rent-free use of the house by

the beneficiary, this amounts to the distribution of all trust income to

the beneficiary as to that asset. Therefore, while this certainly makes

sense for many trusts, trustees of those trusts that are specifically

generation-skipping and GST exempt should think twice about this

arrangement—particularly if there are other sources available for

funding the beneficiary’s home ownership.

○ Example: Under the will of Grandfather, there is a GST exempt trust (that

lasts as long as the perpetuities period allows) and a GST non-exempt

trust. If a grandchild needs financial support to acquire a home, and trust

ownership is determined to be the best approach, all other things being

equal the GST non-exempt trust should acquire the home. The home

represents an asset that can certainly appreciate in value, but its rent-free

use is tantamount to the distribution of income from that asset.

Transfer Tax Issues

− Expense sharing and the cost of improvements should be

carefully considered. As discussed elsewhere, typical recurring

expenses of home ownership, such as property taxes, utilities,

and ordinary maintenance have long been held to be the

obligations of the life tenant or current beneficiary. It would be

appropriate for the current beneficiary to assume those

expenses (though this is not required). Those expenses

associated with the protection and improvement of the

investment, such as capital improvements and hazard insurance,

would be the obligation of the trust or remainderman.

Consequently:

○ The current beneficiary should not pay for improvements or hazard

insurance, as this could be considered a contribution to the trust

and result in a number of nefarious estate and gift tax issues.

Transfer Tax Issues

○ The current beneficiary may assume the other recurring expenses

of home ownership and should be required to do so if possible

since this would, in effect, reduce the cost of the trust’s investment

in the asset and thereby provide additional estate and gift tax

benefits to the family. (This assumes that the trust owning the

house would not be included in the current beneficiary’s taxable

estate.)

− Example: Grandmother creates GST exempt trust for the benefit of

son and his descendants. Son needs a home, and the trust acquires it

and plans to allow the son to occupy it on a rent-free basis. The

trustee should agree with son that son pays (if possible) property

taxes, utilities, and ordinary maintenance, while the trust pays the

hazard insurance and makes any capital improvements. Of course, son

does not have to pay those expenses.

Transfer Tax Issues

○ Transfer Tax Considerations of Beneficiary Home Ownership.

− Trust distribution to fund home acquisition. Of course the least

favorable approach from a transfer tax standpoint is a simple

distribution of income and principal to the beneficiary for the purpose

of acquiring the home.

○ The distribution carries out taxable income to the beneficiary in

accordance with normal rules of trust income taxation.

○ This is the simplest approach to home ownership within the family

context, but also the least advantageous from an estate and gift tax

standpoint.

Transfer Tax Issues

− Trust loan to beneficiary to acquire home. From a transfer tax

standpoint, the effect of this is to freeze the value of the house in the

trust and give the benefit or burden of the value of the home to the

beneficiary. Obviously, this can be good or bad from a transfer tax

(and fiduciary investment) standpoint.

○ Most loan transactions will be structured with the note bearing interest at

the applicable AFR and the trust taking a security interest in the residence.

○ What interest rate will be charged? Most parties default to the applicable

AFR, but this is not absolutely required in a trustee loan context.

Transfer Tax Issues

○ Separate v. Community Property

− General rule is a residence is separate property of a

spouse if it was acquired before marriage, if it was

purchased during the marriage with separate property

funds, or if it was acquired by gift, devise or descent

before or during the marriage. Otherwise, a residence

acquired during marriage is community property.

− Under the “inception of title” rule, the separate or

community character of an asset is determined at the time

the property is acquired and the status of the property

never changes.

Marital Property Issues

− Example: Wife acquires residence prior to marriage. After

marriage, the property remains Wife’s separate property

regardless of improvements or other expenses paid from

community or Husband’s separate funds

− Community presumption- property acquired during marriage is

community property unless proven otherwise. Even if property

is purchased entirely with separate property, the purchase

should be carefully documented as such.

− Debt incurred during marriage—The proceeds from debt

incurred during marriage are presumed to be community

property unless the lender specifically agrees in writing to look

solely to the separate property of a spouse for repayment.

Marital Property Issues

○ Expenses of Residence Paid During Marriage

− To the extent a mortgage on a separate property residence, or

improvements to the residence are paid with community property

during marriage, such payment creates a claim for reimbursement of

the community estate unless it can be proven the mortgage or

improvement was paid with the separate property funds of the spouse

who owns the residence.

− Example: Prior to marriage, Husband purchases “tear down” house.

After marriage, the house is, in fact torn down. With the proceeds of

a typical mortgage (or perhaps a loan from the trust), the couple

builds a very large and expensive home, the value of which far exceeds

the value of the original “tear down” house. The new home is

nevertheless the separate property of the Husband, and the

community estate has a claim for reimbursement against Husband’s

separate property to the extent the community makes payments on

the debt.

Marital Property Issues

− Owner spouse should be sure to pay the following

expenses from separate property, which will otherwise

create a reimbursement claim if paid from community

property:

○ Improvements to the home

○ Hazard Insurance

○ Mortgage/Note

Marital Property Issues

− Property taxes can be paid from separate or community

funds, without creating a reimbursement claim to the

community estate. Other maintenance expenses such as

utilities can also be paid from separate or community

property.

− If the residence is held in Trust, the trust should bear the

costs that the owner spouse would bear (mortgage,

improvements, hazard insurance), leaving other expenses

to the beneficiary.

Marital Property Issues

○ Pros of Holding Residential Property In Trust in View of

Marital Property Issues

− No presumption of community – house was acquired by the Trust, not

either party, therefore there is no presumption of community

− Non-beneficiary spouse should not have a homestead right in the

house, and thus his or her consent will not be required to sell or

otherwise deal with the house (discussed in more detail below below).

− Non-beneficiary spouse should not have any rights as surviving spouse

to live in the house after the beneficiary is deceased (discussed in

more detail below).

Marital Property Issues

○ Potential Cons of Holding Residential Property In Trust

− Though generally accumulated income in a third party trust will not be

subject to community property claims of the non-beneficiary spouse,

there are Texas cases holding that certain rights of the beneficiary

spouse will support a community property claim on accumulated

income, including a withdrawal right, a mandatory income interest, a

general power of appointment, or other similar right to the trust

principal or income.

− In other states, the effectiveness of using a trust to hold real property

as protection against the non-beneficiary spouse’s divorce claim could

be undermined. Some states will consider the size of a trust for the

benefit of one spouse in setting alimony payments. This is not a con

per se, but questions the effectiveness of holding the residence in the

trust solely to avoid a marital property claim.

Marital Property Issues

− Example: Couple marries while Texas residents. Husband is the

beneficiary of a trust created by his parents in Texas. Couple then

moves to Massachusetts and the Trust purchases a home for the

couple in which they live rent-free. Ten years later, the couple

divorces, residents of Massachusetts. Massachusetts law will govern

the division of the marital property, a state where all property no

matter when acquired is subject to equitable division. The court will

likely take the value of the house into consideration when

apportioning non-trust assets, awarding the wife perhaps a greater

share of assets held outside the trust and will similarly take the trust

into account when awarding alimony.

Marital Property Issues

○ Spousal Homestead Right: Required Consents

− In Texas, selling, mortgaging or otherwise disposing of the

primary residence (the “homestead”) of a married couple

requires the consent of both spouses, whether or not the

property is separate or community property.

− If a Trust created by a third party for the beneficiary holds

the residence, the homestead right should not attach, and

the Trustee can sell, mortgage or otherwise dispose of the

residence without consent of the beneficiary’s spouse.

Homestead Issues

− The Texas Property Code specifically provides that if one

spouse transfers his homestead residence to a revocable

trust during marriage, that transfer must be approved of

by the other spouse. Once the spouse has consented and

the transfer is made, the trustee can sell or otherwise deal

with the residence without the consent of the other

spouse. Texas Property Code Section 41.0021(c) and (d).

− It is unclear whether the spouse’s consent is required with

respect to selling or mortgaging a home that was

transferred to a revocable trust before the marriage, as

this particular situation is not addressed in the Property

Code.

Homestead Issues

○ Spousal Homestead Right to Live in the Property.

− Under the Texas Constitution and Texas Estates Code, if one

spouse dies, the surviving spouse has a right to live in the

couple’s homestead for his or her life, whether or not the

property is community or separate property.

− This right likely applies to a residence held in a revocable trust.

− If a Trust, other than a self-settled revocable trust, holds the

property for the beneficiary, this right to live in the residence

after the death of the beneficiary should not attach and the

residence can be disposed of in accordance with the terms of

the trust agreement.

Homestead Issues

○ Property taxes

− Texas Tax Code Section 11.13 provides for a “residence

homestead” exemption that reduces the amount of property

taxes that are imposed against a home. Although individual

cities, counties, school districts, and other taxing authorities

have some ability to vary exemptions, the residence homestead

exemption is equal to 20% of a home’s value for most

purposes. Texas Tax Code Section 11.13 provides additional

exemptions, including a tax ceiling applicable to most school

district and county taxes, for a “residence homestead” of an

individual who is age 65 or older.

Homestead Issues

− Until 2013, a home owned by a trust and occupied by a beneficiary

could qualify as a “residence homestead” only if the beneficiary was a

trustor or the spouse of a trustor and only if the agreement, will, or

court order that created the trust authorized the beneficiary to use

and occupy the residence.

− Section 6 of House Bill 2913 enacted in the 2013 Regular Session

amended Texas Tax Code 11.13(j), effective September 1, 2013, so

that a home owned by a trust and occupied by a beneficiary (including

a non-trustor beneficiary) as the beneficiary’s primary residence can

now qualify as a “residence homestead” so long as the agreement,

will, or court order that created the trust, or an instrument

transferring property to the trust, or any other agreement that is

binding on the trustee provides that the beneficiary has the right to

use and occupy the residence in accordance with certain terms.

Homestead Issues

− The agreement must provide that the beneficiary has the right to use

and occupy the property as the beneficiary’s principal residence rent

free and without charge except for taxes and other costs and expenses

specified in the agreement, and such right must be granted for life, for

the lesser of life or a term of years, or until the date the trust is

revoked or terminated by an instrument or court order that describes

the property and is recorded in the county’s real property records.

− We have drafted a simple two-page agreement that has been

accepted by the Dallas County Appraisal District that grants a

beneficiary a right to use and occupy a residence on a year-by-year

basis that automatically renews at the end of each year unless the

trustee notifies the beneficiary at least 60 days before the end of the

year that the agreement is terminating. The agreement also provides

that it will terminate automatically upon the death of the beneficiary.

Homestead Issues

− The status of a home on January 1 determines whether the home

qualifies for the “residence homestead” exemption for the calendar

year. We suggest that an agreement granting a beneficiary the right to

use and occupy a home be dated and signed before January 1 of the

year for which the exemption is sought. If the agreement is not signed

before January 1, it may be acceptable to use an effective date of

January 1 or earlier if the home was actually owned by the trust and

occupied by the beneficiary on or before the effective date.

− Note that qualifying as a “residence homestead” does not create a

spousal homestead right that otherwise would not be there.

Homestead Issues

Contact Information

Eric G. Reis

Of Counsel

Eric.Reis@tklaw.com

214.969.1118

Sarah G. Woodberry

Associate

Sarah.Woodberry@tklaw.com

214.969.1228

Tyree Collier

Partner

Tyree.Collier@tklaw.com

214.969.1409

William R. Mureiko

Partner

Bill.Mureiko@tklaw.com

214.969.1424