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A personal residence can be an ideal asset to gift to a properly designed trust for your descendants or other beneficiaries.

The basic concept is deceptively simple:  Parent establishes an irrevocable trust for the benefit of children, thereby locking in use of Parent’s lifetime gift exemption as a hedge against a reduction in the exemption by a future Congress.  In addition, if the gifted asset grows in value after the date of the gift, that growth is removed from Parent’s estate.

The devil, as usual, is in the details, including the following:

  1. Can Parent continue to live in the residence? 

The tax law provides that if an individual makes a gift but retains the use of the gifted property, the gifted asset is included in the individual’s taxable estate at death.  Fortunately, there is an exception to this principle if the individual pays fair market value for the value of the retained use.  In other words, if Parent pays a fair market rent to the trust pursuant to a commercially reasonable lease, the residence will not be included in the Parent’s taxable estate.

  1. But won’t the rent create taxable income for the trust?

Not necessarily.  If the trust is structured as a so-called “grantor trust” for income tax purposes, Parent’s rent payments will not be treated as taxable income to the trust.  Under the tax law, if a trust is classified as a grantor trust, then for income tax purposes the trust is treated as if its assets continue to be owned by the grantor.  Therefore, Parent is treated as if he is paying rent to himself, which of course is not a taxable event. 

The concept of a grantor trust can be a mind-bender.  If the trust assets are treated as owned by the grantor for income tax purposes, why are they not also treated as owned by the grantor for estate tax purposes? The answer has to do with historical legal precedents providing that cases that construe the law relating to income tax are not applicable to the interpretation of the law relating to the estate tax.

  1. Who pays the expenses of operating the residence?

As owner of the property, the trust would be obligated to pay expenses ordinarily paid by a landlord, such as real estate taxes and insurance, while Parent would be obligated to pay expenses ordinarily paid by a tenant.  It’s important to ensure that the rent paid to the trust will cover the trust’s share of expenses, or to provide that additional funds will be gifted to the trust if the rent won’t fully cover expenses.

Incidentally, if the rent is more than sufficient to cover the trust’s share of expenses, the excess stays in the trust outside your taxable estate.  So, this is one case where having to pay a high rent is actually a benefit!

  1. Can Parent be evicted from the residence after the gift is made?

Practically speaking, no. The irrevocable trust would have a “friendly” trustee and the Parent would have the power to remove that trustee.

  1.  What are the typical terms of the trust that would own the residence?

Typically, the trust would provide that, during the Parent’s lifetime, the trust would be a single trust for the benefit of all descendants then living with an independent trustee authorized to pay or apply income and principal among the class of beneficiaries as needed. Upon Parent’s death, the trust will divide into separate trusts for the benefit of each child. The trustee would be authorized to distribute income and principal to the child and his or her descendants as needed. Typically, the child’s trust would last for his or her entire lifetime and would be excluded from the child’s taxable estate, meaning that the trustees “generation-skipping” in nature. If the trust is structured of a State such as Florida, they can be designed to keep the assets out of the transfer tax system for up to 360 years. The child’s trust can also be designed so that it is insulated from the claims of creditors and divorcing spouses.

  1. What if Parent wants the property back– can he be a beneficiary of the trust?

No. In general, if the creator of the trust is also a beneficiary, the trust will be included in the creator’s estate. However, Parent’s spouse can be included as a beneficiary of a properly designed trust.

  1. What are the administrative details?
    • Discuss the design of the trust with your Wiggin attorney and have a trust agreement drafted.
    • Open a bank account in the name of the trust to receive the rent payments.
    • Engage a real estate appraiser and have the residence appraised. In addition to providing a valuation of the residence, the appraiser should be asked to provide an opinion as to the fair rental value of the residence.
    • Engage a real estate attorney to prepare a deed transferring the residence from Parent’s name into the name of the trust.
    • Notify your insurance agent to add the trust as an insured for property and liability purposes.
    • Prepare a lease between Parent and the trust.
    • On or before April 15 of the year following the gift, have your accountant file federal (and, if applicable, state) gift tax returns reporting the transfer.

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This memo is designed to inform clients and other interested persons about issues and developments in the law affecting trust and estate administration and estate and tax planning for individuals and their families, fiduciaries, investment advisors and business owners.  Nothing in this memo constitutes legal advice, which can only be obtained as a result of personal consultation with an attorney.  The information provided here is believed to be accurate at the time it was provided, but is subject to change and does not purport to be a complete statement of all relevant issues. 

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