Jeffrey R. Matthews – Page 2

July 26, 2020July 27, 2020

Step Up Your Basis and Beat Capital Gains

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.)

July 26, 2020July 27, 2020

Residential Property in 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.

July 26, 2020July 28, 2020

Rights of Survivors to Homestead, Exempt Property and Allowances

Have you ever heard of a “forced share” (historically called “widow’s share”) when it comes to dealing with estate assets? Whether a decedent had a will or not, his surviving spouse and children might have rights to estate property which trump the rights of other interested parties, including other beneficiaries and most creditors.

For example, the intestacy statutes provide that when a decedent having no will dies with children who are not also children of his surviving spouse, the children (and not his spouse) inherit his half of the community property and most of his separate property. This can become troublesome for surviving spouses, who will effectively become co-owners with their step-children. In many cases, the step-children might demand that the spouse agree to sell the property or pay them rent.

Texas law protects surviving spouses and children in various ways.

Homestead and Exempt Personal Property

Chapter 353 of the Texas Estates Code provides for setting aside the homestead and exempt personal property. Section 353.051(a) states:

… the court by order shall set aside:

(1) the homestead for the use and benefit of the decedent’s surviving spouse and minor children; and

(2) all other exempt property described by Section 42.002(a), Property Code, for the use and benefit of the decedent’s:

(A) surviving spouse and minor children;

(B) unmarried adult children remaining with the decedent’s family; and

Note that only minor children benefit from the homestead set-aside, while certain adult children can benefit from the exempt personal property set-aside.

For more information on the type and extent of real estate which qualifies as a homestead, see this article.

Chapter 102 of the Estates Code provides that the spouse and minor children have the exclusive right to use and occupy the homestead for the duration of their lives rent-free. The case law holds they need only pay for property taxes and do not have to keep the home insured. In addition, they must pay the interest portion (and not the principal) of any unpaid mortgage. The remainder owners are responsible for the principal portion of the mortgage.

Example:

Don is married to Sally and has an adult son, Ben, from a prior marriage. Prior to his marriage to Sally, Don owned the home Sally and he live in. Therefore, it is his separate property. Don and Sally have a lot of credit card debt. Sally files a petition for divorce from Don. Don changes his will to leave everything he owns to Ben.

Don dies before the divorce proceedings are finalized. Regardless of Don’s will, Sally receives a life estate to occupy the home for the remainder of her life rent-free. She is required to pay property taxes and the interest portion of the mortgage. She does not have to insure the home. She is required to maintain it at her expense.

Ben must pay the principal portion of the mortgage. If he wants the property to be insured, he will have to pay for the insurance himself. He cannot force Sally to sell the home. He has no right to occupy it so long as Sally occupies it as her homestead.

Since Ben might be waiting many years before he is entitled to do anything with the home, this rule provides incentives for one party to cash-out the other.

As stated in Section 353.051(a)(2) above, exempt personal property is also set aside for Sally. Ben gets none of it.

Allowances in Lieu of Exempt Property

Section 353.053 provides:

(a) If all or any of the specific articles of exempt property described by Section 353.051(a) are not among the decedent’s effects, the court shall make, in lieu of the articles not among the effects, a reasonable allowance to be paid to the decedent’s surviving spouse and children as provided by Section 353.054.

(b) The allowance in lieu of a homestead may not exceed $45,000, and the allowance in lieu of other exempt property may not exceed $30,000, excluding the family allowance for the support of the surviving spouse, minor children, and adult incapacitated children provided by Subchapter C.

What this means is this: If there is no homestead, or if there is debt against the homestead, the survivor can give up any homestead rights and elect to receive an allowance of up to $45,000. If there isn’t much exempt personal property, the survivor can receive an allowance of up to $30,000 in addition to the exempt personal property. The amounts to be awarded are within the discretion of the court or independent executor.

Set Asides are not Subject to Administration

Allen v. Ramey makes clear that the foregoing set asides of the homestead and exempt personal property remove these assets from the estate. This means they cannot be used to pay debts of the estate, including the family allowance discussed below.

Family Allowance

In addition to the foregoing set-asides and allowances, Section 353.101, et seq. provides for a family allowance for each surviving spouse, minor child and adult, incapacitated child equal to the person’s expected needs for living expenses for the first year after the decedent’s death. The amount to which each person is entitled will be reduced to the extent he or she had his or her own separate property at the time of the decedent’s death.

The family allowances take precedence over the rights of all other beneficiaries and heirs to property of the estate and also trump the claims of all creditors, except for Class 1 claims (i.e., the first $15,000 of funeral expenses and the first $15,000 of expenses of last illness).

According to Estate of Nielsen, the family allowance is payable out of the entirety of the decedent’s and surviving spouse’s community estate and not solely out of the survivor’s half. It is a debt of the estate to be paid out of administration and may not be satisfied using homestead and exempt personal property which has been set aside.

There are a lot of interesting scenarios and questions which pertain to exempt property and allowances in connection with decedent’s estates. As shown above, these exemptions and allowances are very powerful and can be rather generous since they are to the exclusion of other beneficiaries, heirs and most creditors of the estate.

July 26, 2020July 27, 2020

What is a Homestead?

Chapter 41 of the Texas Property Code deals with homestead exemptions.

Section 41.001(b) of the Texas Property Code provides that a homestead is subject to a foreclosure or execution sale by creditors only for the following types of debts:

(1) purchase money;

(2) taxes on the property;

(3) work and material used in constructing improvements on the property if contracted for in writing as provided by Sections 53.254(a), (b), and (c);

(4) an owelty of partition imposed against the entirety of the property by a court order or by a written agreement of the parties to the partition, including a debt of one spouse in favor of the other spouse resulting from a division or an award of a family homestead in a divorce proceeding;

(5) the refinance of a lien against a homestead, including a federal tax lien resulting from the tax debt of both spouses, if the homestead is a family homestead, or from the tax debt of the owner;

(6) an extension of credit that meets the requirements of Section 50(a)(6), Article XVI, Texas Constitution; and

(7) a reverse mortgage that meets the requirements of Sections 50(k)-(p), Article XVI, Texas Constitution.

For example, a person’s home will be protected even though he defaults on credit card debts, car loans, tort liability, student loans and many other types of debts.

In addition, the surviving spouse and minor children of the decedent are entitled to have the homestead set aside for their exclusive use and benefit, rent-free, for the duration of their lives. It doesn’t matter in whose name the property is titled as long as it is part of the decedent’s estate. In addition, it doesn’t matter whether the decedent’s will or the laws of intestacy leave the home to somebody else. (For more on the rights of survivors of decedents, see this article.)

Urban vs. Rural Homesteads

Section 41.002 defines the amount of property which qualifies either as an urban or rural homestead. It states:

Sec. 41.002. DEFINITION OF HOMESTEAD. (a) If used for the purposes of an urban home or as both an urban home and a place to exercise a calling or business, the homestead of a family or a single, adult person, not otherwise entitled to a homestead, shall consist of not more than 10 acres of land which may be in one or more contiguous lots, together with any improvements thereon.

(b) If used for the purposes of a rural home, the homestead shall consist of:

(1) for a family, not more than 200 acres, which may be in one or more parcels, with the improvements thereon; or

(2) for a single, adult person, not otherwise entitled to a homestead, not more than 100 acres, which may be in one or more parcels, with the improvements thereon.

(1) located within the limits of a municipality or its extraterritorial jurisdiction or a platted subdivision; and

(2) served by police protection, paid or volunteer fire protection, and at least three of the following services provided by a municipality or under contract to a municipality:

(A) electric;

(B) natural gas;

(D) storm sewer; and

(E) water.

Notice that as long as the property meets the definition of a homestead, it is exempt, no matter what its value is and no matter how much equity is in it.

Unimproved Property

Unimproved property can qualify as homestead in many circumstances. The most important factor is the intent of the owner to use the property as a homestead as manifested by his objective conduct. For example, if the owner has entered into a contract to build a home on the property which he intends to live in, the property will typically qualify. Intent is a fact-driven question and can be shown in many different circumstances. In rural cases, unimproved property can qualify as part of a homestead even if the owner never intends to live there. This is discussed below.

Multiple Tracts

While an urban homestead can consist of multiple tracts as long as they are contiguous, a rural homestead can consist of non-contiguous tracts – even when they are miles apart. A common situation is where a rural resident has separate acreage nearby which he uses to graze livestock, raise crops or engage in some similar use “for purposes of a rural home.”

There is case law holding that a family business, such as an auto body shop, qualifies as property used “for purposes of a rural home.” There is also case law holding that developing a rural tract into rental properties does not qualify when the owner does not live on the property. However, temporarily renting all or part of a homestead will not result in loss of its protections.

It is important to be very careful when changing the use of, or leasing, all or even a part of the homestead property. An attorney should be consulted to make sure the new use or lease will not be deemed “abandonment” of the homestead.

Abandonment

When a homestead is abandoned, it no longer maintains its exempt status. A classic example is when the owner keeps his existing home as a rental property and moves into a new home. The new home will qualify as a homestead, but the rental home no longer does. Abandonment can occur in a variety of ways. However, for married persons, a spouse cannot abandon the homestead without the consent of the other spouse. This rule is important in the context of separation and divorce.

Proceeds of Sale

Section 41.001(c) of the Property Code provides a window of opportunity for owners to sell their homes and reinvest the proceeds into a new home. The proceeds are exempt for 6 months from the date the home is sold.

Be Careful when Putting Homesteads into Trusts

It is a somewhat common estate planning practice to put one’s homestead in a trust – either in an inter vivos trust (made during life) or in a testamentary trust (a trust created in a person’s will). Caution should be exercised when putting homes into trusts. Unless the trust is a “qualifying trust,” the owner can lose the valuable property tax homestead exemption and worse, he can lose the homestead to general creditors. (You can read more about “qualifying trusts” in this article.)

Don’t Lose Your Step-Up in Basis

There is a huge difference between gifting property, including your homestead, during your life versus holding onto it until death. (Read more about it here.)

Homestead laws are varied and complex. It is always a good thing to know your rights so you can plan appropriately.