This is another in a series of blogs on the basics of estate planning. Over the past two weeks, I’ve looked at the insurance, tax, and asset protection considerations involved in transferring real estate into a trust.
This week, I’ll touch on funding issues unique to irrevocable trusts, as well as those unique to revocable trusts.
Typically, there are two categories of issues to consider when deciding whether to transfer real estate into an irrevocable trust. Both stem from the fact that, under normal circumstances, the purpose of these transfers is to remove the value of the property from the grantor’s estate for estate tax purposes.
- Transfer Tax Issues: In order to get the property out of the grantor’s estate, the grantor needs to make a completed gift to the irrevocable trust. This usually means filing a gift tax return. Also, beware of the grantor retaining too much control over the disposition of the property once in the trust, such as a sprinkling power – this could cause the property to be included in the grantor’s estate. (See IRC § 2038). Sometimes, the grantor wants the property out for asset protection or Medicaid planning, but in the taxable estate for estate tax purposes in order to get a step-up in income tax basis. This may be achieved by giving the grantor a limited power of appointment. Such a power would give the grantor the power to decide to whom the assets go, but excludes the grantor, the grantor’s estate, and the creditors of both of them as permissible appointees.
- Income Tax Issues: Assuming the gift into the trust is complete and the property is not included in the grantor’s estate for estate tax purposes, there will be no step-up in the property’s basis when the grantor dies. Think carefully about the loss of this step-up in basis before deciding to transfer real estate into an irrevocable trust. This is a very fact-intensive decision. For example, if the property is a vacation home which the client intends to stay in the family for generations, the basis may make little difference. Essentially, the present value (at the decedent’s death) of the future capital gains tax should be compared with the presumed estate tax savings. In this era of an estate tax exclusion of well over $5 million, it is increasingly common for clients to want to trigger inclusion in the taxable estate in order to get the step-up in basis.
When deciding whether to fund property into a revocable trust, you should take into account the impact of any property agreement on the transfer into the trust.
Once your clients’ real estate is funded into the trust, will it be tenancy in common property, community property, or some other form of property? If community property is available in your jurisdiction, it is typically the best option (assuming your clients are a married couple, of course).
Community property qualifies for a step-up in basis on the entire property at the death of the first spouse, not just the decedent’s one-half. Tenancy in common property, on the other hand, qualifies for a step-up in basis only on the half included in the decedent spouse’s estate.
Believe it or not, there are still a few more issues to think about when funding real estate into a trust. Next week, I’ll have another blog with several additional considerations of which you’ll want to be aware before deciding to make a transfer of real estate into a trust.
In other upcoming blogs, I’ll discuss more on the basics of estate planning.
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
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