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    Difficult Trust Question

    Client's brother established an irrevocable inter vivos trust several years ago, funding it with $1000. Since then, the trust corpus has grown to a value of roughly $85000, due to additional contributions of assets by the original grantor (my client's brother) and other family members, and also due to investment income.

    My client is the only beneficiary of the trust as long as she is alive. After her death, any remaining assets in the trust go to a charitable educational entity. However, this is not a charitable remainder trust. It appears to be a spendthrift trust, originally intended to prevent my client from squandering the money, and to shield the assets from creditors.

    The trustee is my client's same-sex partner. The terms of the trust give the trustee absolute and total discretion as to when or whether to make any kind of distribution; no distribution is ever required. The only real requirement is that the trustee act in the best interest of my client, and the terms prohibit any distribution to the educational institution as long as my client is alive.

    Yes, the trust has its own TIN and has been filing Form 1041.

    The issue:

    My client wants to put a rental property that she owns into the trust. The property consists of three rental units, and she has owned it for about 15 years. She currently holds title to it as an individual.

    Superficially, this looks totally clean and uncomplicated. She has been reporting the rental income, expenses, and depreciation on her personal Schedule E for the last 15 years.

    But it gets really complicated really fast. The property has an estimated FMV of $140,000, a mortgage of about $80,000, and a basis of.... well, let's just say that the basis is probably well below the FMV because of all those years of depreciation on Schedule E and appreciation of the property itself.

    Her motives for transferring the property into the trust are not entirely clear to me. It appears that she wants to prevent the property from going to family members, and give her partner control over the property and its equity and income, thereby shielding it from creditors but nevertheless remaining available to her down the road if she becomes incapacitated, mentally or physically, and begins to incur massive medical expenses. I'm not absolutely certain of this, but it sounds like she wants to shield the asset from attachment or inclusion for purposes of Medicaid eligibility. But she may have other motives as well. Most of her family is hostile to her partner.

    My client has envisioned three different mechanisms by which the property could be transferred into the trust:

    (1) She transfers the property into the trust with a quit-claim deed. This will trigger the due-on-sale clause in the mortgage, and the trust will simply pay off the mortgage with its current liquid assets.

    (2) She pays off the mortgage with her own money first, then transfers title to the trust.

    These two scenarios have the same outcome: my client is making an outright gift to the trust. The only difference is the value of the gift. If she pays off the mortgage first, the value of the gift is much greater.

    (3) She sells the property to the trust at its fair market value, determined by a competent appraisal. The trust purchases the property in an arms-length transaction, using part or all of the trust's current assets to make a downpayment, and then taking a mortgage for the rest of the purchase price. My client would not sign the mortgage note. She believes that the trust may be able to borrow on its own, because of the trust's assets and the rental income generated by the property. Alternatively, the trustee might agree to accept personal liability on the mortgage note, to get a better interest rate.

    The questions:

    (a) If my client gifts the property, as described in scenarios (1) and (2), does this successfully avoid any capital gain until the trust sells the property? Does the trust use her basis? Does the trust start depreciation all over?

    Or is the gift disregarded because she is the beneficiary of the trust?

    She appears to be retaining a beneficial interest, although this isn't crystal clear to me because the trust itself is irrevocable. She can't get the property back unless the trustee decides to make a distribution and transfer title back to her. We're assuming that will never happen. Even if it did, it would not be at her direction; she is giving up complete control of the property. She will certainly continue to receive some income from it, but only if and when the trustee decides to make distributions.

    (b) What happens if my client sells the property to the trust, as described in scenario (3)? This would appear to be a full blown final disposition, with all the consequences of capital gain.

    But is the sale disregarded because the property was sold to a related party? Once again, she is the beneficiary of the trust. And this appears to meet the definition of a related party.

    (c) If my client gifts the property to the trust, she becomes a grantor to a trust of which she is also a beneficiary. The trust is not a grantor trust, because the original grantor was not a beneficiary, and the trust is irrevocable. But the fact remains that if she makes the gift, there will be an individual who is both a grantor and beneficiary of this trust.

    Does this poke a hole in the shield they are trying to create with respect to Medicaid and other hypothetical creditors? Or will the trust survive an attack if they can get past whatever "look-back" period applies to "self-settled" trusts?

    This is an Ohio affair.

    TIA

    Burton
    Last edited by Koss; 03-08-2006, 01:10 AM.
    Burton M. Koss
    koss@usakoss.net

    ____________________________________
    The map is not the territory...
    and the instruction book is not the process.

    #2
    I’m not an expert in this area, but you could be looking at a grantor trust even though you say it is irrevocable. TTB, page 21-17 says if income is for the benefit of the grantor, it is a grantor trust.

    “The grantor or a non-adverse party has the power to either distribute income to or for the benefit of the grantor or spouse….”

    If you have a same-sex domestic partner as the trustee, the law may view that person similar to a spouse. Gifting your property to a trust that is under your spouse’s control to distribute income would make it a Grantor trust, which is basically ignored for federal tax purposes. So this could be viewed in the same light.

    I would have an attorney who is an expert in the tax consequences of revocable and irrevocable trusts look at this. If it really is a Grantor trust, your client has just wasted a ton of money on trusts that do not do anything from a tax perspective.

    Comment


      #3
      I hope Natiro can help here, I believe he knows a thing or two about trusts.

      I find your questions very interesting and would like to ask you to post the outcome.

      Thanks Burton, and good luck.

      Comment


        #4
        What a mess. I hate to get an attorney involved unless it's absolutely necessary, but if it were me, I would enlist the help of an experienced trust and estate attorney. I would be concerned about liability problems for myself and the client, and from what you've already stated, I don't trust this client.

        Comment


          #5
          trust question

          First of all, if you haven't done so, you should review the trust document. The document is the first place to go to determine what is and is not allowed, particularly as far as funding goes. I would assume the document would probably indicate what initially funded the trust and how additional funds can be added, if at all. I would be surprised if the beneficiary can add funds or property to the trust, but again, the trust should say.

          I don't see any reason why your client couldn't sell the property to the trust, at FMV. You mentioned that you thought this might be disregarded, as a sale between related parties but I don't believe that would be the case. In fact, I think the gain would be ordinary gain, for sale of appreciated depreciable property between related parties. (If the property is depreciable property in the buyer's hands) And I believe that in this case, your client would be considered a related party. IRC 1239(a)

          Another issue to think about is that if the rental is in a trust and there is rental income and no current year distributioins, the income may be taxed at a higher rate than your client's personal rate. If there is a rental loss inside the trust, the loss is treated as passive (no 25,000 special allowance for the trust) and will be suspended until there is a taxable disposition of the property. There are some interesting rules regarding depreciation taken on trust property, but I won't go into that here.

          If this is all about medicaid, I can't help you there. But I would definitely recommend your client see an attorney who specializes in trusts / estates and/or medicaid planning to insure that what she ends up doing will accomplish what she hopes to.

          To specifically answer one of your other questions, if she is able to add to the trust and she gifts the property, she will avoid the capital gain tax completely (as a general rule). The trust itself would pay the capital gain tax upon the sale, unless the trust document specifically states that capital gains are to be paid out to the beneficiary or if the trustee makes a regular habit of paying out the capital gains. The trust would use her basis. Basis of gifted property carries over (since FMV exceeds the basis in this case.)

          All in all, I would start with the trust document and go from there. Also, state law governing trusts, creditor protection, etc, differ from state to state, so she really should consult with an attorney, too.

          PS, for Gabriele. . .thanks for the vote of confidence. . .just wanted to let you know that Natiro is a she, not a he!

          Comment


            #6
            Ha, natiro, you have it easy with my name. I have been wrong before with determining with sex people have who post on this board. Anyway, I am glad you share your knowledge.

            Some years, I mistook a male for a female and he told me a little story about his grandfather, who would tease his granddaughters and say: When I was a little girl....
            It took the girls a while to figure out that he was teasing them.

            Comment


              #7
              Thanks

              Thanks for all the input, particularly Natiro, but everyone else, too. This gives me some direction.

              The trust instrument does indeed allow additional contributions to the trust, at any time, by anyone, even <i>anonymous</i> contributions, with the caveat that the trustee can choose whether or not to <i>accept</i> the contributions. This is some pretty far-out stuff...

              "Related party" had my mind warped. I knew it would have an effect on the sale. But I agree that it would not be disregarded. The related party sale makes the gain ordinary income instead of capital gain, and that would be disaster for my client.

              I don't think the gift makes it a grantor trust. It's already a complex trust that is not required to distribute all income. You can't go backwards. Some assets in the trust were not donated by the beneficiaries. A grantor trust is a disregarded <i>entity</i> in that a true grantor trust, because of it's unique revocable nature, does not have to file its own return and does not have to have its own TIN.

              But even for a trust that is a true grantor trust, not all <i>transactions</i> are disregarded. In this case, when the trust was created, it was most certainly <i>not</i> a grantor trust. The contribution of new assets by one beneficiary does not somehow transform the trust into a grantor trust.

              The sale is out of the question. Gifting the property might work. We may indeed consult an attorney.

              Thanks to all!

              Burton
              Burton M. Koss
              koss@usakoss.net

              ____________________________________
              The map is not the territory...
              and the instruction book is not the process.

              Comment

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