Category: Estate Planning and Probate

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Gifts: No Annual Limit or Taxes for Most of Us

There are popular misconceptions concerning limits and taxes applicable to gifts.  I’ll get straight to the point:  Unless you are very wealthy, there will be no tax of any kind associated with gifting.

Recipients of gifts never pay a tax on the gift under any circumstances.  If there is to be a tax on a gift, it is paid by the estate of the donor when he dies.

Here’s how it works:

There is a federal estate tax which applies only to very wealthy people.   It is calculated based on the wealth the donor owns at the time of death, plus the wealth he gave away while he was alive.

Why are gifts added?  To close a loophole.

Imagine being worth $100 million and giving it all away on your deathbed to avoid paying taxes.  The IRS isn’t going to have any of that.  So, they count your gifts, too.  However, they only count gifts to the extent they exceed the annual exclusion in the year given.  This allows wealthy people to make fairly generous gifts each year and to also avoid a limited amount of estate taxes.

The 2024 annual gift exclusion is $18,000 per donee.  If you give $100,000 to your child, you must report it to the IRS since it exceeds the exclusion.  This doesn’t mean you will be taxed.  It only means that in 2024, you gave $82,000 in value that will be taxed only if you are rich enough.

How rich?

The federal estate tax kicks in at $13.61 million for single individuals and $27.22 million for married couples.  These figures are known as the “unified federal estate tax credit.”  The excess $82,000 will only be taxed if you are over the unified credit when you die.  Otherwise, it’s completely tax free.

The bottom line is that unless you are very wealthy, you can give it all away anytime you want, and nobody will pay any gift taxes.  But be very careful when making gifts.  You don’t want to lose a valuable step-up in basis.  You can read about the step-up here.

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Muniments of Title: A Quicker, Cheaper Type of Probate Proceeding

I am often asked to explain the benefits to be derived from probating wills as muniments of title when it can be done that way.  Here is a recent explanation I gave:
You asked what an estate administration is.   It’s a process of settling the debts of a decedent and distributing any remaining property to his beneficiaries.  It’s very much like a bankruptcy proceeding or liquidation process.
An estate administration requires following a rule-based process of liquidation, which includes publishing notice to creditors in the newspaper to advise them to submit their claims to the executor.  In addition, secured creditors have to be provided notice by certified mail to make their claims against the estate.  There is a period of time which must pass for all this process to complete.  During that time, the executor must also file a formal Inventory, Appraisement and List of Claims with the court (or documents in lieu thereof, provided the executor represents to the court that the Inventory has been completed and will be made available to creditors and estate beneficiaries).  All of this requires time, paperwork and money.  It shouldn’t be hugely expensive, but still, it’s work that is unnecessary and which prevents wrapping up the estate quickly.
My understanding is there are no debts other than the mortgage and a few unpaid bills that don’t add up to a lot.
As you can see, the procedure of estate administration is geared toward paying creditors before distributing what remains.  If there are no creditors, then there’s no need to publish notices to them and to send them letters in the mail, etc.  There’s no need to wait a certain amount of time to see if anyone out there submits a claim.  There will be no need for the executor to approve or deny claims, etc.
When there are no debts, other than debts secured by real estate, there’s a simplified type of probate available called a “muniment of title.” This is not a typo, and I didn’t mean to say, “monument.”  It’s pronounced:  myoon-a-mint.
I’ll show you the statute in a second, but basically, when a will is admitted to probate as a muniment of title, no administration is had on the estate.  The court simply enters an order to the effect that the decedent’s property is now owned by the people named in the will.  This order is all the authority you need to demonstrate to the world that you are now the owners of the property.  Think of the order as chaining the title of your father’s assets to you.  The order proves your ownership.
Once an order is entered admitting a will to probate as a muniment of title, the estate proceeding is closed.  There’s nothing further to do.  The order constitutes authority for third parties to treat you as the owners and deal with you, directly, rather than with an executor going through an administration.
You can take a look at Chapter 257 of the Texas Estates Code, allowing for probate as a muniment of title.  Section 257.102 describes the effect of the order as I stated above.
All of the provisions dealing with estate administration are contained in Subtitles G, H and I of the Texas Estates Code.  If you want to look those up, the table of contents of all the Texas statutes is here.  You’ll probably not want to read too much there, but suffice it to say, among all those statutes are all the requirements of an administration – all of which are avoided if a will is admitted to probate as a muniment of title.
So, pay off the small debts so we can tell the court that there are no debts other than debts secured by real estate.  Then, we can authorize the court to admit the will to probate as a muniment of title.
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Will Drafting – Dealing with Abatement of Bequests

Abatement of gifts is an issue that can be anywhere from unimportant to extremely important, depending on individual circumstances.  The amount of your wealth is not what makes the difference.

Abatement occurs when debts and expenses of administration must be paid.  The law does not assume that all of your beneficiaries must share the debts and expenses equally.  The money has to come from somewhere.  So, whose shares pay what amounts?

This might already be a little confusing.  Here is a simple situation to make the point:

Suppose your will says, “I leave my home to Allan and everything else to Beth.”  This simple expression does not tell us whether you intend Allan and Beth to receive an equal value or not.  We know nothing about the worth of the home, nor do we know the value of everything else.

To keep it simple, let’s say the home is worth $300,000, and everything else is worth $300,000.  You intend to treat Allan and Beth equally.

Note that the respective values can change a lot over time, and while the intent at the time of making the will is to treat Allan and Beth equally, later changes in value can make the disposition very unequal.  For now, let’s assume the values never change.  Equality is assured… or is it?

The answer is, “Definitely not.”  At the time of passing, if you have debts, other than a mortgage or lien on your home, the law assumes you want Beth to pay all of them out of her share.  Similarly, the law assumes you want Beth to pay all of the expenses of estate administration out of her share.

Let’s assume your home is paid for.  You have $5,000 in credit card debt; $30,000 in medical bills related to your final illness; and $15,000 in funeral expenses.  $5,000 will be required to pay an attorney and other expenses of estate administration.

Beth pays all of these.  That’s $55,000.  The net result is Allan receives $300,000 in value from your estate, and Beth receives $245,000.

Instead of medical bills being only $30,000, let’s assume they were $350,000.  In this case, we now have a total of $375,000 in debts and expenses.  Beth’s share is exhausted.  There remains unpaid indebtedness of $75,000.  Allan’s home must be sold.  Assuming no closing costs, he’ll receive $225,000 after the creditors are all paid.

As you can see, this is what happens with simple estates.  Imagine what’s involved as giving becomes a little more complicated.  Now, you can appreciate how rules of abatement can adversely impact even the simplest plan.

The failsafe approach to treating a group of beneficiaries equally is to avoid bequests and devises when possible.  Treat your entire estate as the residue and leave it in fractional shares or percentages.

The simplest example is, “I leave everything to Allan and Beth in equal shares.”  Notice that now, there’s no distinction between the type or description of property between the 2 recipients.  They get exactly the same thing.  In addition, later changes in the value of specific property will not affect the value that both Allan and Beth will receive.

Bequests, devises and residue are important concepts when it comes to abatement.  All of these are gifts made in your will, but devises hold a higher status than bequests.  Bequests hold a higher status than the residue.

Devises are gifts of real property outside of the estate’s residue.  Bequests are gifts of personal property outside of the residue.  The residue is everything which remains after all bequests and devises are made.

As you can see, Texas law places a higher status on real property than personal property.  There’s probably not a great reason for this distinction.  However, it’s the rule.

The best way to understand how bequests, devises and the residue are related comes from our simple example above.    You can see that your will made a devise of your home to Allan, and it left the residue to Beth.

Since the devise to Allan enjoys a higher status than Beth’s residue, Beth gets stuck with the debts and expenses.  As I stated above, if your intent is to treat Allan and Beth equally, the best way is to avoid the devise to Allan.  Again, your will could simply state, “I leave everything to Allan and Beth in equal shares.”

If you can be satisfied with a will like this, it’s definitely the way to go.  However, there might be compelling reasons which drive you to want to make some devises or bequests.  A good example would be a bequest of money to your favorite charity – “I leave the sum of $10,000 to my church (we’ll keep the name generic), and I leave everything else to Allan and Beth in equal shares.”

Obviously, if you want to leave $10,000 to your church, there’s no way to avoid a bequest.   By now, you know the law assumes that the church’s share will not be reduced by any of your estate’s debts and expenses until the residue is first exhausted.

The bequest to the church is a good example to lead into one more nuance – that is, whether a bequest (or devise) is specific or general.  A gift (whether it is a bequest or devise) is specific if it can be satisfied without coming from other property.  In our original example, the gift of the home to Allan is a special devise.  The home is the gift, itself.

The gift to the church, on the other hand, is of money.  It is a general bequest because it will have to come from other property in order to be satisfied.

The rule is that specific bequests and devises take priority over general bequests and devises.

Got it?  Good!

There’s one final nuance.  Intestacy.

Intestacy occurs when property of your estate is not disposed by your will.  Intestacy is a real concern, but it is beyond the scope of this article.  Here’s an example just to keep it as simple as possible:  “I leave everything to my friend, Bob.”

This will fails to state what happens if Bob fails to survive you.  Where does your stuff go?  Actually, we’re not going to answer that question here, but now, you can see how intestacy occurs even when you have a will.

You’ve learned a heck of a lot if you’ve understood everything so far.  So, without further ado, here’s Section 355.109 of the Texas Estates Code:

ABATEMENT OF BEQUESTS. (a) Except as provided by Subsections (b), (c), and (d), a decedent’s property is liable for debts and expenses of administration other than estate taxes, and bequests abate in the following order:

(1) property not disposed of by will, but passing by intestacy;

(2) personal property of the residuary estate;

(3) real property of the residuary estate;

(4) general bequests of personal property;

(5) general devises of real property;

(6) specific bequests of personal property; and

(7) specific devises of real property.

(b) This section does not affect the requirements for payment of a claim of a secured creditor who elects to have the claim continued as a preferred debt and lien against specific property under Subchapter D.

(c) A decedent’s intent expressed in a will controls over the abatement of bequests provided by this section.

(d) This section does not apply to the payment of estate taxes under Subchapter A, Chapter 124.

Did you see subsection (c)?  This is your “out” if you don’t like the way Section 355.109 works.

In our original example (“I leave my home to Allan and everything else to Beth.”), I showed that one way to obtain equal treatment (if that’s the goal) is to remove the devise to Allen and instead, to leave everything to Allan and Beth in equal shares.

But what if you’d really prefer to leave the gifts like you had them in the first example?  No problem.  Your will could contain an optional provision overriding the default rule, like this:

I leave my home to Allan and everything else to Beth.

I direct that all gifts herein shall abate in proportion to their values.

Now, Allen pays half of the debts and expenses from his share, and Beth pays half from hers.  (Just remember, the values can change later, and the result will vary.)

We can also add the special bequest of $10,000 to the church without any reduction for debts and expenses.   Your will now reads:

I leave $10,000 to my church.

I leave my home to Allan and everything else to Beth.

I direct that all gifts herein, other than general bequests, shall abate in proportion to their values.

We’ve covered a lot, but there’s one more thing.  What if there’s a mortgage on the home of say, $100,000?  Section 255.301 of the Texas Estates Code provides:

NO RIGHT TO EXONERATION OF DEBTS. Except as provided by Section 255.302, a specific devise passes to the devisee subject to each debt secured by the property that exists on the date of the testator’s death, and the devisee is not entitled to exoneration from the testator’s estate for payment of the debt.

However, you can change this result if you like. Section 255.302 states:

EXCEPTION. A specific devise does not pass to the devisee subject to a debt described by Section 255.301 if the will in which the devise is made specifically states that the devise passes without being subject to the debt. A general provision in the will stating that debts are to be paid is not a specific statement for purposes of this section.

Using our example, Allan will have to pay the $100,000 mortgage on the home all by himself unless your will states other property should be used to pay it.

These are just a few of the limitless possibilities when it comes to planning for abatement of gifts.  This article should not be understood to suggest that altering the statutory rule is always a better approach.  It’s only better when it accomplishes a purpose that the statute’s default rules cannot.  Once you decide on your goal, the trick is to use the proper tools to achieve it.

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LA Supreme Court: DIY Wills are a Bad Idea

With the proliferation of legal forms on the internet, people often consider doing their own wills to try to save money.   If you’re not a trained lawyer, you probably assume the wills you find on the net meet legal requirements just because “they’re there.”  That is a very dangerous assumption as you are getting ready to see.

The 2017 case of Toney, out of Louisiana, is the perfect example to bring this point home.  In Toney, the Louisiana Supreme Court denied probate of a will which a non-lawyer scraped off the internet and tried to customize.

The will’s attestation clause and self-proving affidavit looked valid and would probably fool 10 out of 10 non-lawyers.  They had all the legal-sounding jargon everyone expects to see.

The attestation clause of the will stated:

We, the undersigned, hereby certify that the above instrument, which consists of 3 pages, including the page(s) which contain the witness signatures, was signed in our sight and presence by Ronnie R. Toney (the “testator”), who declared this instrument to be his/her Last Will and Testament and we, at the Testator’s request and in the Testator’s sight and presence, and in the sight and presence of each other, do hereby subscribe our names as witnesses on the date shown above.

The self-proving affidavit stated:

I, Ronnie R. Toney, the Testator, sign my name to this instrument this 2 day of August, 2014, and being first duly sworn, do hereby declare to the undersigned authority that I sign and execute this instrument as my Will and that I sign it willingly, in the presence of the undersigned witnesses, that I execute it as my free and voluntary act for the purposes expressed in the Will, and that I am eighteen years of age or older, of sound mind, and under no constraint or undue influence.

Testator Signature: Ronnie R. Toney [signed]

Ronnie R. Toney

We, Angela Dutel and Robert A. Davis and William Orazio, the witnesses, sign our names to this instrument, being first duly sworn, and do hereby declare to the undersigned authority that the Testator signs and executes this instrument as the Testator’s will and that the Testator signs it willingly, and that the Testator executes it as the Testator’s free and voluntary act for the purposes expressed in the will, and that each of us, in the presence and hearing of the Testator, at the Testator’s request, and in the presence of each other, hereby signs this will, on the date of the instrument, as witnesses to the Testator’s signing, and that to the best of our knowledge the Testator is eighteen years of age or older, of sound mind and memory, and under no constraint or undue influence, and the witnesses are of adult age and otherwise competent to be witnesses.

Can you spot anything wrong in those 2 passages? I doubt it. However, the Court found the issues and started its discussion by telling us what the requirements are for a valid will:

In Succession of Brown, 458 So.2d 140, 143 (La.App. 1 Cir. 1984), the First Circuit succinctly summarized the three required elements of a valid attestation clause under La. R.S. 9:2442(B)(2), La Civ. Code. art. 1577(2)’s similarly-worded counterpart, as follows:

The attestation clause set forth in the statute… requires the notary and witnesses to declare (1) the testator signed the will at its end and on each separate page, (2) the testator declared in the presence of the notary and witnesses that it (the instrument) was his will, and 3) in the presences of the testator and each other, they (the notary and witnesses) signed their names on a specified date.

(Emphasis in original.) In this case, none of these three requirements is fully met.  As to the first requirement, although the third page of the will states it “was signed in our [the three witnesses’] sight and presence,” it does not mention that the will was signed on each separate page as specified in the sample attestation clause.

Additionally, neither the will nor the affidavit contains a declaration that the notary viewed the will being signed (only the affidavit is notarized). Similarly, as to the second clause, although the witnesses signed a clause affirming that the testator “declared this instrument to be his/her Last Will and Testament,” the notary made no such declaration. Finally, as to the third requirement, although the witnesses declare “to the undersigned authority… that each of us, in the presence and hearing of the Testator … and in the presence of each other, hereby signs this will, on the date of the instrument” (emphasis added), the witnesses do not mention signing the will in the presence of the notary…

In his brief, the applicant suggests that the testament at issue originated from a form found on the internet. This hypothesis is supported by the appearance of the word “COUNTY” in the affidavit. Although we are sympathetic to the fact that a testator could errantly use such a form in ignorance, to hold the propounded testament in substantial compliance with La. Civ.Code. art. 1577 would essentially negate any value to the distinct form requirements which our legislature has chosen to put in place.

So there you have it.  Toney officially died without a will.   That had to feel like a punch in the gut for the people he named as his beneficiaries.

Most estate-planning documents are fairly straight-forward and won’t break the bank to have a qualified attorney prepare.

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Step-Children and No Will: A Recipe for Disaster

Do you or your spouse have step-children?  Do you want to leave part of your estate to your step-children (for example, if your spouse predeceases you)?  Then, you better have a will.

Before further discussion, it is helpful to know that persons who die without wills are said to be “intestate.”  This word is used in statutes referenced below.

Unmarried Persons with Step-Children

What if you’re not married but you have step-children?  What part of your estate will they get if you die without a will?  Section 201.001 of the Texas Estates Code answers this question.  And the answer is…

Zip.  Zero.  Nada!

Married Persons with Step-Children

If you’re married, we have to look to Sections 201.002 and 201.003 of the Texas Estates Code.  Section 201.002 deals with a decedent’s separate property, while Section 201.003 deals with a decedent’s community property.

Community property is actually defined by what it is not.  Section 3.002 of the Texas Family Code states, “Community property consists of the property, other than separate property, acquired by either spouse during marriage.”  If you are not married, you do not have community property.

Separate property is defined in Section 3.001 of the Texas Family Code.  A spouse’s separate property consists of:

(1) the property owned or claimed by the spouse before marriage;

(2) the property acquired by the spouse during marriage by gift, devise, or descent; and

(3) the recovery for personal injuries sustained by the spouse during  marriage, except any recovery for loss of earning capacity during marriage.

There are many nuances to these general rules.  For example, income earned from separate property is community property.  Also, property acquired from the proceeds or disposition of separate property remains separate property.  This article does not attempt to cover all the nuances relating to characterization of property as “community” or “separate.”

Looking at Sections 201.002 and 201.003 of the Texas Estates Code, we can see the same result.  Step-children get a goose egg.  Nothing.

Conclusion

If you or your spouse has step-children and you want to leave any part of your estate to them, you must have a proper will.  If you fail to plan properly, the only thing they’ll be entitled to is disappointment.

 

 

 

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The Case against Survivorship Accounts

I have had numerous clients tell me over the years that they’re not sure who they designated as beneficiaries on their checking, savings, investment and retirement accounts.   Many are not even sure whether they named any beneficiaries.

When something changes in life for them (a divorce, death of a spouse, death of a child, or just changing their mind about how to leave their assets, etc.), they have to wonder about all the places where they have to go and fix the beneficiary designations.

Contrast that approach with the traditional, simple will.  If all of your accounts are payable to your estate, they simply go to whomever you designate in your will.  That’s much smarter because it’s much more efficient.  It’s much less prone to errors.  Errors in estate-planning can be very costly.  The simpler, the better.  Just have a will and update it (and only it) as necessary.  Do not set up beneficiary designations on your accounts.  That way, they will all go to your estate by default.  You will never have to update them.

The argument against my advice is that, “Probate is slow and costly.”  It’s not.  In most cases, an executor in a will can get letters testamentary within 3-4 weeks.  It’s a largely bureaucratic process that is pretty automatic.

I would suggest that if a “survivorship account” is necessary, there should be only one, and it should be just for normal expenses for a few months, or so.

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It’s Easy to Save Your Home from Medicaid

An applicant must have limited assets to be eligible for Medicaid. In most cases, owning a home will not disqualify the applicant.  In order to keep the home in the family and not lose equity in it to the state of Texas upon the Medicaid recipient’s death, a Transfer on Death deed will be required.

Medicaid’s 5-Year Lookback Rule

When applying for Medicaid, applicants must disclose all transfers of assets made within the previous 5 years. The purpose of this rule is to disqualify applicants who give away all their wealth in order to impoverish themselves to become Medicaid eligible.   

In short, making a gift of the home (and any other assets) might keep the property in the family, but it can disqualify the donor from receiving Medicaid.

Medicaid Reimbursement

In Texas, Medicaid recipients must reimburse the state of Texas out of their estates when they die.  If the recipient’s home passes through his estate, it will be subject to the state’s claim for reimbursement. 

Section 373.203(a) of Title 1 of the Texas Administrative Code expressly limits Medicaid reimbursement to estates as follows:

The Medicaid Estate Recovery Program (MERP) may file or present a: Class 7 probate claim under §298, Claims Against Estates of Decedents, Texas Probate Code, against the estate of deceased Medicaid recipients in accordance with the priorities contained in §322, Classification of Claims against Estates of Decedents, Texas Probate Code.

Notably, if the home is not part of the recipient’s estate when he dies, it will not be subject to reimbursement.  To avoid the home being part of his estate, the recipient can make a gift of it, but as stated above, it can result in ineligibility for Medicaid.

In any event, now it is clear that the task at hand is to save the equity in the home by insuring it passes to family members outside of the Medicaid recipients estate and in a manner that will not disqualify him from receiving Medicaid or other public benefits.

This can be done via a non-probate transfer.

Probate vs. Non-probate Transfers

When a person dies, his estate will consist of all assets owned at the time of death, except assets which are transferred outside of the person’s estate.

For example, life insurance which is payable to a beneficiary upon the insured’s death passes outside of the insured’s estate. Likewise, bank accounts set up as “pay on death” (POD) accounts to named beneficiaries also pass outside of the account-holder’s estate.

These types of transfers are known as “non-probate transfers.”  There are many other types of non-probate transfers, and this article does not attempt to list all of them.  The main purpose is to make a simple distinction between probate and non-probate transfers.  Probate transfers are all transfers of property which occur upon the death of the owner, except for non-probate transfers.  Probate transfers occur through the decedent’s estate, and as stated above, such property will be subject to the state’s claim for reimbursement.

The key takeaway is that property which passes upon death by way of a non-probate transfer is not considered to be property of the decedent’s estate. 

Ladybird Deed

A type of deed called a “Ladybird deed” is one way in which Medicaid recipients try to keep their homes out of their estates.  Ladybird deeds are widely used, but this does not mean they are without controversy.

On the one hand, the applicant does not want to become ineligible for having made a gift during the lookback period. On the other hand, the Ladybird deed often reserves a right of the applicant to sell or mortgage the property and keep the proceeds. This hardly sounds like anything was transferred at all – meaning it could cause inclusion of the home within the applicant’s probate estate.

Suffice it to say, the Ladybird Deed is a clever device, but there has been some degree of uncertainty as to their effectiveness.

Texas’ Solution: the Transfer on Death Deed

Chapter 114 of the Texas Estates Code was created to alleviate these concerns .  It enables families to preserve their home equity by using a Transfer on Death (TOD) deed.

By giving a TOD deed, the Medicaid recipient retains all rights of ownership during his lifetime. He can sell the property. He can mortgage the property. He continues to receive all benefits of home ownership protections and property tax exemptions.  He can even revoke the TOD deed.

Section 114.101 states:

During a transferor’s life, a transfer on death deed does not:

(1) affect an interest or right of the transferor or any other owner, including:

(A) the right to transfer or encumber the real property that is the subject of the deed;

(B) homestead rights in the real property, if applicable; and

(C) ad valorem tax exemptions, including exemptions for residence homestead, persons 65 years of age or older, persons with disabilities, and veterans;

(2) affect an interest or right of a transferee of the real property that is the subject of the deed, even if the transferee has actual or constructive notice of the deed;

(3) affect an interest or right of a secured or unsecured creditor or future creditor of the transferor, even if the creditor has actual or constructive notice of the deed;

(4) affect the transferor’s or designated beneficiary’s eligibility for any form of public assistance, subject to applicable federal law;

(5) constitute a transfer triggering a “due on sale” or similar clause;

(6) invoke statutory real estate notice or disclosure requirements;

(7) create a legal or equitable interest in favor of the designated beneficiary; or

(8) subject the real property to claims or process of a creditor of the designated beneficiary.

Notice that Section 114.101(4) expressly states a TOD deed will not affect the transferor’s eligibility for public benefits.  

Section 114.106(b) makes clear that the property will not be considered as part of the recipient’s estate.  It states:

… real property transferred at the transferor’s death by a transfer on death deed is not considered property of the probate estate for any purpose, including for purposes of Section 531.077, Government Code.

Section 531.077 of the Texas Government Code is the statute which provides that the state of Texas will seek Medicaid reimbursement from the estates of decedents.  It states:

Sec. 531.077. RECOVERY OF CERTAIN ASSISTANCE. (a) The executive commissioner shall ensure that Medicaid implements 42 U.S.C. Section 1396p(b)(1).

(b) The Medicaid account is an account in the general revenue fund. Any funds recovered by implementing 42 U.S.C. Section 1396p(b)(1) shall be deposited in the Medicaid account. Money in the account may be appropriated only to fund long-term care, including community-based care and facility-based care.

As stated at the beginning of this article, Section 373.203(a) of Title 1 of the Texas Administrative Code is the rule which limits reimbursement to the recipient’s estate.   As long as the property is not considered to be a part of the recipient’s estate, it will pass free from the state’s reimbursement claims.

In conclusion, every homeowner who receives Medicaid benefits should execute and file a Transfer on Death deed in order to preserve the home’s equity for his or her beneficiaries.

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Can You Trust Your Trust… to Save You Taxes?

There are good reasons why you might want to leave part of your estate in trust. Maybe an intended beneficiary is not a good money manager and will blow through your estate if given the chance. Trusts can be used to limit his or her access to trust assets and income.

Trusts can do even more than that. Similar to the corporate form of doing business, trusts can protect assets from the creditors of your beneficiaries.

In addition, trusts can be used to provide for a series of generations, such as to your children for their lives and then, to your grandchildren. This type of design can have the effect of keeping property “in the family” as opposed to winding its way through the in-laws’ families after a generation or two.

There are many other reasons why trusts might be appropriate, but they are not necessarily well-suited to income and estate tax avoidance. This article will explore some basic tax issues which are in play.

History of the Federal Estate Tax Exemption

Check out this chart showing how the federal estate tax exemption amount has risen since 1997:

In just 23 years, the exemption increased from $600,000 to almost $12 million! Not even the stock markets have boomed like this. Moreover, there hasn’t been a down year yet – not even in 2009-2011 when Democrats held the White House and both chambers of Congress.

This massive acceleration in the federal estate tax exemption has changed the tax planning paradigm completely. Think about all those people who made estate plans back in 2008 and earlier. Many of those outdated plans have not only become obsolete, but they are actually tax traps that can easily cost a person hundreds of thousands of dollars, if not millions. Keep reading, and it will become very obvious why this is the case.

Let’s examine a typical trust plan.

Assume Ted Testator has a taxable estate. He wishes to leave all of his estate to his only child, Charles, who in turn will leave his estate to his children (Ted’s grandchildren).

Ted’s estate will be taxed upon his death. If Ted leaves everything to Charles, the same property will be taxed again upon Charles’ death (assuming Charles will also have a taxable estate).

Generation Skipping

To avoid taxing the property twice, Ted can leave everything directly to his grandchildren. This is called “generation skipping.” The IRS is aware of this strategy, and the tax laws permit it to a limited extent. Generation skipping transfer taxes are beyond the scope of this article, but the simple generation skipping plan described above easily makes the point that double taxation can be avoided.

Let’s say Ted does not want to bypass Charles completely. Trusts can be used to skip Charles without really skipping Charles. A typical trust plan for Ted will leave everything in trust, naming Charles as an income beneficiary for life, and distributing the property to the grandchildren outright after Charles dies. Charles is also named as the trustee, and he is permitted to pay trust principle to himself for his health, education, maintenance, and support (HEMS).

For all practical purposes, this type of trust gives Charles virtually complete control over the trust property. It’s like he owns it… but he doesn’t! It’s not part of his estate when he dies, and no estate tax will apply. Mission accomplished… or not?

This is where it gets slippery.

No Step-Up in Basis

While estate tax avoidance is accomplished, Charles does not own the property. It is in trust. This means, the property will not receive a step-up in basis when Charles dies. Basis is an important tax consideration not to be overlooked.

The basis of an asset is often its acquisition price. For example, if Ted purchased unimproved land in 1980 for $1 million and did not make improvements on it, its basis in 2020 is still $1 million – the price paid. If Ted sells the property for $7 million in 2020, there is a $6 million capital gain, and he will have to write a hefty check to Uncle Sam. This is income tax, not estate tax.

Instead of selling the property in 2020, assume Ted dies, and it goes into trust as mentioned above. As a result of his death, the property’s basis will be stepped-up to its fair market value at the time of Ted’s death (i.e., $7 million). If Charles, as the trustee of the trust, sells the property for $7 million, there will be no capital gain. That’s a lot of income tax saved. You can read more about the importance of a step-up in basis here.

So far, so good…

But What about when Charles Dies?

Suppose Charles dies in 2050, when the property – having been put into trust for his benefit – has greatly appreciated and is then worth $20 million. Since he was not the owner upon his death, the property will not receive a step-up. The basis remains at $7 million – the fair market value upon Ted’s death back in 2020. If the grandchildren sell the property after Charles’ death for $20 million in 2050, they will pay a large sum in taxes on their $13 million capital gain.

If Ted would have left the property outright to Charles, rather than in trust, the grandchildren would have enjoyed a step-up in basis upon Charles’ death. They could then sell the property for $20 million without incurring any capital gain tax liability.

But Charles’ Estate will Incur Estate Tax if He Owns the Property upon His Death!

Who says? Although there is plenty of talk about how Congress or the next President is going to stick it the rich, history indicates this is somewhat unlikely.

Who knows what the estate tax exemption amount will be in 2050? It has risen from $600,000 in 1997 to over $11 million in 2018. Perhaps it could be $30-40 million by 2050. It might even be repealed.

The takeaway here is that when property will significantly appreciate over time, the step-up in basis upon death is very valuable and not to be overlooked. Given the way the estate tax exemption has been growing over the last two decades, it is possible that both estate taxes and capital gains taxes can be avoided. The trust, in our example, failed to accomplish that result since it forfeited the step-up in an effort to avoid estate taxes via generation-skipping. In essence, the skip – which was supposed to save the grandchildren millions of dollars – actually cost the grandchildren millions of dollars.

What about 2025?

In 2025, the current $11.58 million estate tax exemption amount is slated to expire. This means that unless Congress takes action to maintain or increase it, it will automatically revert to $5 million (adjusted for inflation) at the end of 2025. This sort of scenario can make people nervous.

For example, if Ted’s estate is currently valued at $8 million, no tax would be due if he dies prior to the end of 2025. If he dies in 2025, his estate will be subject to estate taxes unless Congress does something.

There are two things to note about this situation.

First, it happened before, in 2012. At that time, the exemption was $5 million, and it was going to revert to $1 million at the end of 2012. Congress did not take action as quickly as people had hoped, and in a last-minute frenzy, many wealthy people started gifting away property. Then, on January 1, 2013, before anyone had a chance to die that year, Congress passed the American Taxpayer Relief Act which extended the $5 million exemption amount.

Admittedly, hindsight is 20/20, but much of that gifting frenzy was for naught. Even worse, all those gifts transferred the owners’ basis to the donees. In essence, the step-up in basis was lost and there was no estate tax savings to be derived from the gifts. That’s a double-whammy for calling it wrong!

Another important point to note is that by leaving estate property to Charles outright, rather than in a generation-skipping trust, he will at least have the option to (i) retain it until death for the step-up in basis, or (ii) forego the step-up and gift it to avoid estate taxes on his death. Being able to make the right call at the closest point in time has massive advantages. Charles is much more likely to know the tax landscape in 2050 than is Ted. Unless there is a really good reason, Ted has no business trying to guess what the tax landscape will be 30 – 40 years down the road.

The generation-skipping trust in our example takes away Charles’ option to keep or gift the property. If the property is in trust, there will be no opportunity to receive a step-up in basis, regardless of what the estate tax and income tax landscape looks like in 2050. As has been shown, planning too rigidly too soon can be a very costly mistake.

This is not to say that all trusts are bad. As stated above, there are many good reasons to leave property in a trust. It is also possible to structure trusts in a manner to include property in a beneficiary’s estate. If the trust in our example gave Charles a testamentary general power of appointment over the trust property upon his death, then the property would be included in his estate and it would receive a step-up in basis, while protecting the property from his creditors during his lifetime.

A testamentary general power of appointment is the power to give the property upon death (typically by a will provision) to one’s estate or the creditors of one’s estate (among anyone else). The following is an example: “… in trust, naming Charles as an income beneficiary for life, and distributing the property upon his death to such persons as he shall designate in his last will and testament, provided that such persons may include only my grandchildren and the creditors of Charles’ estate.” (By not allowing Charles to appoint the property to his estate, this language prevents Charles from leaving the property to his spouse and keeps the property “in the family,” as described earlier.)

Again, however, an outright gift of the property to Charles would give him the option of keeping it in his estate to receive a step-up, or gifting it to avoid estate taxes. Sometimes, clients need this flexibility; sometimes, they don’t.

Conclusion

There is no crystal ball when it comes to planning for estate and income taxes. All we have to go on is a track record and the current state of politics. Looking at the chart above, the track record indicates that we should expect the exemption amount to rise substantially over the coming years – maybe even be repealed.

This article demonstrated how old and outdated tax planning strategies can do tremendously more harm than good. Trusts can be very useful, but they can also be very dangerous. Don’t just trust your trust to save you taxes. Verify it.

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Step Up Your Basis and Beat Capital Gains

Tax Return
Suppose Don bought unimproved real estate 35 years ago for $100,000 and now it’s worth $550,000.  Don’s tax basis is $100,000.  If he sells the property at its current value, he will have a capital gain of $450,000, which will come with a fairly large income tax liability.
If Don makes an inter vivos (during life) gift of the property, whether in trust (with some exceptions, see below) or as an outright gift, he transfers  his basis to the donee(s).  Therefore, the donee will be subject to the same capital gains tax liability upon selling the property.
Don, now up in age, fears rumors about the pitfalls of probate proceedings.  He tells his attorney to prepare a deed so he can give the property to his son now and avoid probate.  When the deed is delivered, his son’s basis is $100,000.  Don dies the following month.  Don’s son then sells the property for $550,000 and incurs a $90,000 tax on the capital gain.
Instead, suppose Don’s attorney advises Don to hold on to the property until his death.  Property which is held in the estate of a decedent receives a step up in basis equal to the property’s fair market value at the date of death.  If Don leaves the property to his son upon his death, his son’s basis will be stepped up to $550,000 (its fair market value).  If Don’s son sells for $550,000, there will be no gain for tax purposes.  If Don’s son sells for $600,000, his capital gain will be $50,000 (resulting in a tax liability of only $10,000).
Want to help your children get the most out of your estate?  For all but very wealthy people, the plan should be to die with it rather than give it away during life.

What about Trusts?

Caution should be exercised with trusts.  In many scenarios, trusts are oversold by attorneys when there is no rational need for one.  Simply “avoiding probate” is not a good enough reason.
There can be many good reasons for putting property into trusts.  Common ones include caring for disabled children, protecting the property from creditors of the grantor’s beneficiaries, limiting access to beneficiaries who are poor money managers, and estate tax avoidance.
When the grantor contributes property to a trust, the IRS will still consider it as owned by the grantor (i.e., not a gift and therefore qualifying for the step up) in certain, limited situations – such as when the trust is revocable at the sole option of the grantor or when the grantor has a life estate in the income from the trust.
In addition, caution should be used when homesteads are held in a trust.  (Read about this here.)
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Residential Property in Trusts

Trusts

In Texas, a person’s homestead has a special status in two respects. First, Sections 11.13 – 11.135 of the Texas Property Tax Code provides for property tax exemptions for homesteads. Second, Chapter 41 of the Texas Property Code states that a person’s homestead is exempt from his general creditors. You can read more about these provisions here.

These privileges are specific to individual owners who occupy their homes. For example, homestead exemptions generally are not available for rental properties. Likewise, property held in a business entity, such as an LLC, will not be exempt from general creditors.

So what about trusts? Quite often, real estate is held in trust for the benefit of the trust’s grantor or for the benefit of one or more beneficiaries.  Can a home held in trust qualify for both privileges?

The answer is “yes,” so long as the homestead property is in “qualifying trusts.” What is a qualifying trust?  Due to a recent bankruptcy court opinion, the answer is no longer as clear as many practitioners previously believed.

Section 11.13(j)(3) of the Property Tax Code states:

“Qualifying trust” means a trust:

(A) in which the agreement, will, or court order creating the trust, an instrument transferring property to the trust, or any other agreement that is binding on the trustee provides that the trustor of the trust or a beneficiary of the trust has the right to use and occupy as the trustor’s or beneficiary’s principal residence residential property rent free and without charge except for taxes and other costs and expenses specified in the instrument or court order:

(i) for life;

(ii) for the lesser of life or a term of years; or

(iii) until the date the trust is revoked or terminated by an instrument or court order that describes the property with sufficient certainty to identify it and is recorded in the real property records of the county in which the property is located; and

(B) that acquires the property in an instrument of title or under a court order that:

(i) describes the property with sufficient certainty to identify it and the interest acquired; and

(ii) is recorded in the real property records of the county in which the property is located.

This is the statute relating to property tax exemptions.  Pay attention to the emphasized text.

Now, let’s look at the Property Code to see what a qualifying trust is when it comes to protecting the homestead from your general creditors.   Section 41.0021 states:

HOMESTEAD IN QUALIFYING TRUST. (a) In this section, “qualifying trust” means an express trust:

(1) in which the instrument or court order creating the express trust provides that a settlor or beneficiary of the trust has the right to:

(A) revoke the trust without the consent of another person;

(B) exercise an inter vivos general power of appointment over the property that qualifies for the homestead exemption; or

(C) use and occupy the residential property as the settlor’s or beneficiary’s principal residence at no cost to the settlor or beneficiary, other than payment of taxes and other costs and expenses specified in the instrument or court order:

(i) for the life of the settlor or beneficiary;

(ii) for the shorter of the life of the settlor or beneficiary or a term of years specified in the instrument or court order; or

(iii) until the date the trust is revoked or terminated by an instrument or court order recorded in the real property records of the county in which the property is located and that describes the property with sufficient certainty to identify the property; and

(2) the trustee of which acquires the property in an instrument of title or under a court order that:

(A) describes the property with sufficient certainty to identify the property and the interest acquired; and

(B) is recorded in the real property records of the county in which the property is located.

In the case of In re: Cyr, the U.S. Bankruptcy Court of the Western District of Texas, San Antonio Division, held that the Property Tax Code’s phrase, “rent free and without charge” means something different than the Property Code’s phrase,  “at no cost.”

The result was that the debtor was entitled to a break on his property taxes, but his home was subject to the claims of his general creditors!

What exactly the distinction is between “rent free and without charge” and “at no cost” seemed to elude even the bankruptcy court, itself, when it commented as follows in its opinion:

… “at no cost” is broader than “rent free and without charge” and conceivably includes costs and expenses other than those related to rent.  (emphasis added)

Sadly, the debtor “conceivably” lost his homestead!

Cyr is not a a good decision to have on the books, and as of the time of this article, it remains the only authority on this point.  Some practitioners, including me, believe there is a substantial likelihood that if (when) this issue arises again in another court, we will wind up with a split in authority.