REAL ESTATE AND LIVING TRUSTS: A CHECKLIST OF ISSUES TO CONSIDER

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1 Spring 2015 Editor: Julius Giarmarco, J.D., LL.M. Tenth Floor Columbia Center 101 West Big Beaver Road Troy, Michigan (248) Fax (248) Assistant Editor: Salvatore J. LaMendola, J.D. REAL ESTATE AND LIVING TRUSTS: A CHECKLIST OF ISSUES TO CONSIDER By Salvatore J. LaMendola, J.D. Introduction When conveying real estate to a living trust, a number of issues must be considered. They are broken down into five main categories: tax issues, creditor issues, insurance issues, mortgage issues and Medicaid issues. A discussion of each follows. Tax Issues Principal Residence Exemption. The owner of a principal residence in Michigan may apply for and receive a principal residence exemption (formerly called the homestead exemption) from a portion of local school operating taxes. The transfer of a residence to a living trust does not negate the exemption. MCL 211.7dd(a)(vi). However, to avoid any argument, the trustee of the living trust should file a Principal Residence Exemption (PRE) Affidavit (Michigan Department of Treasury Form 2368) with the local assessor (unless the assessor has determined that this is unnecessary). After that, the next tax assessment should be reviewed to confirm that the benefit of the exemption was received. Property Taxes. Unless an exemption applies, a transfer of ownership will lift the cap on the taxable value of real property and, in the subsequent year, the taxable value will be set at the state equalized value for that year. One type of transfer that is exempt from this uncapping is a conveyance to a living trust, provided that the sole present beneficiaries of the trust are the settlor, the settlor s spouse, or both. MCL a(6)(c)(i). Within 45 days of the transfer, a Property Transfer Affidavit (Michigan Department of Treasury Form 2766) with the living trust exemption indicated (box 7 on the current form) should be filed with the assessor to avoid a fine of up to $200. (Where industrial or commercial property is concerned, the maximum fine for a late filing can be up to $1,000 if property worth $100 million or less is involved, and $20,000 if properly worth more than $100 million is at issue.) After the filing, the next tax assessment should then be reviewed to confirm that no uncapping occurred. At the settlor s death, an uncapping will also be avoided if the beneficiary receiving a residence from the living trust is a relative of the settlor (within a certain degree of relation) and if the property is not used for any commercial purpose after receipt. MCL a(6)(c) (ii). Federal Income Taxes. Due to the settlor s reserved power to amend or revoke a living trust, living trusts are treated as grantor trusts for federal income tax purposes. Internal Revenue Code (IRC) 676. Thus, the transfer of real estate to a living trust triggers no income tax problems. And, while still a grantor trust, the sale of a principal residence by a living trust qualifies for the $250,000 gain exclusion ($500,000 for a husband and wife on a joint return) available under IRC 121. Treas. Reg (c)(3). Also, while still a grantor trust, if a principal residence is involuntarily converted by destruction or condemnation, the postponement of taxation on the gain under IRC IN THIS ISSUE: REAL ESTATE AND LIVING TRUSTS: A CHECKLIST OF ISSUES TO CONSIDER IS IT A TRUST ASSET OR NOT? HOW NOMINEES MAY HOLD TRUST ASSETS SHOULD ANNUITIES EVER GO INTO AN IRA?

2 when the insurance proceeds received for the lost principal residence are reinvested in a new principal residence within 2 years from the end of the taxable year in which the conversion occurred is allowed. PLR Lastly, while still a grantor trust, the settlor of the living trust that holds the principal residence retains the benefit of the IRC 163 home mortgage interest and IRC 164 real property tax deductions to the same extent as if the settlor owned the residence outright. PLR At the settlor s death, all living trust assets (all real estate included) qualify for a step-up in basis under IRC Michigan Income Taxes. As Michigan indirectly adopts the federal concept of grantor trusts by basing its income tax on an individual s federal adjusted gross income (AGI), the IRC 121 and 1033 gain exclusions, as well as the IRC 1014 basis step-up, would both be available at the state level too. The IRC 163 and 164 deductions are subtracted from federal AGI. Thus, they are of no use in Michigan, whether the home to which the mortgage interest and property taxes pertain is owned outright or in a living trust. Federal Gift Taxes. Again due to the reserved power to amend or revoke a living trust, transfers to living trusts are incomplete gifts for federal gift tax purposes. Note, however, that if a transfer to a living trust occurs after the power to amend or revoke has become permanently (as opposed to temporarily) unexercisable (e.g., a transfer to the trust by a settlor s agent acting for an incapacitated settlor under a durable power of attorney), a completed gift will be made, with no deduction for the settlor s reserved life estate, unless some other provision contained in the trust instrument (such as general power of appointment in the settlor) renders the gift incomplete. State and County Transfer Taxes. Since a transfer to a living trust is for $0 consideration (i.e., the settlor receives $0 back from the trust), the under $100 consideration exemption applies for both state transfer taxes (MCL (a)) and county transfer taxes (MCL (a)). No form need be filed to claim these exemptions. Instead, language stating that neither transfer tax applies is included in the deed itself. Creditor Issues Homestead Exemption. Not to be confused with the former name of the Principal Residence Exemption (nor with the Homestead Property Tax Credit for Michigan income tax purposes, nor the homestead exclusion for Medicaid purposes), in 2015, Michigan homesteads are protected in bankruptcy up to $37,775 of equity ($56,650 if the homeowner is age 65 or older or is disabled). MCL (m). For non-bankruptcy, the Michigan homestead exemption amount is a mere $3,500. MCL (1)(g). Since the former statute describes the interest of the debtor and the latter statute, the following property of a judgment debtor, and since each statute fails to address living trust ownership, it is best to assume that these exemptions would be unavailable for as long as the homestead is held by the living trust. Entireties Protection. Except where a federal tax lien, federal criminal fine, or forfeiture from a federal criminal case is involved, a married couple that owns real estate as tenants-by-theentireties is immune from all creditors, unless judgment is entered against both spouses (such as with a loan personally guaranteed by both spouses, or where both spouses are mortgagors on a property). MCL (1)(n); MCL a. Michigan law is not clear as to whether property held by both spouses as co-trustees of a living trust would enjoy the same protection. Accordingly, if creditor protection is a major concern, and if only one spouse is engaged in the transaction or activity that could give rise to liability, a married couple would be better off waiting until after the first death to convey to a living trust. Insurance Issues Title Insurance. Under the older (pre ) title insurance policies, living trusts as grantees were not included in the definition of insured. Thus, a conveyance to a living trust meant the trustee of the trust could not make a claim if a title defect (e.g., liens, unpaid taxes, unpaid mortgages, etc.) later arose. Where a conveyance to a living trust of a property covered under an older policy will be made, an additional insured endorsement should be purchased (usually at minimal cost) to extend coverage to the living trust. Alternatively, if the property has appreciated significantly since acquisition,

3 3 a new title policy acquired by the trustee for increased coverage might be better. Under the newer title insurance policies, the term insured now includes living trust grantees. Thus, for a property insured under a newer contract, no interruption of coverage upon transfer to the trust should occur. That said, it is always best to confirm one s own particular case with one s own particular carrier. Homeowner s Insurance. No matter when a homeowner s policy was obtained, before conveying to a living trust, the transferor should make certain with his/her carrier that coverage will not be interrupted. If it would be, an endorsement to the policy adding the living trust as an additional insured should be obtained. Umbrella Insurance. If possible, adding the living trust to any umbrella insurance policy is advisable. Mortgage Issues Due-on-Sale Clauses. A due-on-sale clause allows a lender to declare due and payable any outstanding balance on a loan if the property securing the loan is sold or otherwise transferred without the lender s consent. An exemption applies to a loan that is secured by a mortgage on residential real property containing less than 5 dwelling units. 12 USC 1701j-3(d)(8). Although this exemption covers transfers to living trusts of which the borrower is and remains a beneficiary, the safer course is to check with the bank or mortgage company beforehand to make sure the loan will not be called after the conveyance occurs. For properties not falling under the exemption, asking the lender to sign a document stating that it will not demand full payment upon transfer is the best approach. Refinancing. Although some lenders will be comfortable that their security interest in the trust-held property will not be jeopardized if the trustee closes on the new loan, most will require that the property be transferred back to the settlor, who then closes, and who then re-conveys back to the trust. Medicaid Issues Under the Medicaid rules, if the total equity value of the homestead does not exceed $552,000 (2015), the value of the homestead will be excluded for Medicaid purposes. If the spouse or an under-age-21, blind or disabled child of the Medicaid applicant lives in the homestead, the homestead exclusion is unlimited. In Michigan, for the exclusion to apply, title to the homestead must not be held in a revocable trust. For single persons, this means returning the homestead to the living trust settlor and exploring other probate avoidance techniques to avoid estate recovery upon the Medicaid recipient s death. For married couples, this generally means the same, with the non-medicaidrecipient spouse who would hold exclusive title, adjusting his/her own estate plan to avoid disqualifying the Medicaid recipient spouse, if the former dies first. Conclusion Tax, creditor, insurance, mortgage and Medicaid issues all come into play when real estate (especially the principal residence) will be conveyed to a living trust. To avoid surprises, careful consideration should be given to all of the above before the transfer is made. IS IT A TRUST ASSET OR NOT? HOW NOMINEES MAY HOLD TRUST ASSETS By Thomas P. Cavanaugh, J.D. The Michigan Trust Code provides for a trustee s duties and liabilities, many of which (but not all) may be modified by the trust agreement. Trustees have the responsibility to marshal and secure trust assets. Generally, trustees are not responsible for assets which are not titled in the name of, or payable to, the trust. In order for an asset to be owned by the trust, does it have to be titled in the name of, or payable to, the trust? Under the Michigan Trust Code, the answer is no. While in most circumstances trust assets bear the name of that trust, it is not necessary. MCL provides:

4 4 a trustee has all of the following powers: (o) To hold property in the name of a nominee or in another form without disclosure of the interest of the trust. However, the trustee is liable for an act of the nominee in connection with the property so held. This nominee power is a default provision under the Michigan Trust Code and may be modified by a trust agreement. For those trusts which are silent as to whether or not a trust asset may be held in the name of a nominee, MCL (o), as cited above, applies. Simply stated, a nominee is a third person or entity that holds assets in his or her name, without giving notice that the asset is actually held in a fiduciary capacity. Many times this occurs in the case of securities to alleviate a trustee from having to comply with documentary requirements typically imposed by corporations when securities are retitled in a trustee s name. Michigan is one of many states that have enacted nominee statutes that permit a trustee to hold securities in nominee form (MCL , et seq). Moreover, MCL (o) explicitly allows a trustee to hold real estate, cash accounts, and other assets in the name of a nominee so that title may pass by delivery. (N.B.: Trustees are liable for any act of their nominee.) So, how does this work in actual trust administration? If a trustee does not want others to know that a particular asset is owned by the trust, it may allow that asset to be titled in the name of a company, or by an individual (in many cases, the trustee him/herself). In either case, proper administration dictates that separate documentation is signed by all parties involved memorializing that the listed owner is only acting as the nominee and that the asset is legally owned by the trust. In addition to the Michigan Trust Code, there are other statutes which also permit particular assets to be owned in nominee form, such as: The Corporate Fiduciary Stockholders Act, Uniform Commercial Code, Uniform Act for the Simplification of Fiduciary Transfer, Business Corporation Act, Cemetery Regulation Act, Insurance Code, etc. Again, all these statutes give a trustee the power to hold property in the name of a nominee. What happens when the settlor of a trust dies or becomes disabled and an asset is titled in the settlor s individual name? Is that asset part of the settlor s trust because the settlor was holding the asset as nominee for the trust? For example, say that a settlor suffers a disability and owns a $50,000 savings account titled in his name alone. Is this savings account an asset of the trust or not? Was the settlor holding this account as nominee for his trust? An argument can be easily made that if there is a transfer on death beneficiary named (which is not the trust), then the settlor did not intend for this particular asset to be owned by his or her trust. Sometimes settlors will include language in their trust agreements which specifically references assets that are not intended to be owned or payable to their trusts (in order to avoid litigation over such an issue). If there are no named beneficiaries on the account, this author believes that most judges would require some documentation memorializing that the settlor intended for such an account to be held in his/her name as nominee for the Trust; otherwise, it is expected that a probate court judge would deem the account to be a non-trust asset. SHOULD ANNUITIES EVER GO INTO AN IRA? By Julius H. Giarmarco, J.D., LL.M. Internal Revenue Code (IRC) Section 72 provides annuities with a tax preference in the form of taxdeferred growth. IRAs also enjoy tax-deferred growth under the IRC. Thus, given the similarities between IRAs and annuities, should an IRA ever purchase an annuity? Obviously, if the only purpose of the annuity is tax-deferred growth, the answer is no. The reason is the additional expenses associated with annuities (see below). However, in the early 2000s annuity carriers added new riders to their variable annuities, such as guaranteed living benefits, enhanced death benefits and unique investment features (equity-indexed annuities). And, with certain fixed annuities, superior fixed income yields. Given these guarantees, having an IRA purchase an annuity may make sense for some IRA owners. Riskadverse individuals, in particular, may find that the guarantees associated with annuities offer them the security they desire. In fact, according to the Investment Company Institute, 35% of households with IRAs have annuities in their IRAs.

5 5 Another situation in which it might make sense to mix an annuity with an IRA is to manage required minimum distributions (RMDs) (so that penalties are avoided) while assuring income lasts a lifetime. By purchasing an immediate annuity about the time RMDs must begin, the carrier takes care of the RMD compliance and guarantees that the payments will continue for the chosen period (e.g., the IRA owner s life or the joint life of the IRA owner and his/her spouse). Of course, the IRA annuity must meet the RMD rules. Depending on the type of annuity, the annual distributions may be larger than the RMD if the IRA owner did not buy an annuity. One downside to this approach is less flexibility. If an emergency arises, the IRA owner s ability to draw additional funds from the annuity is limited. Another downside to an immediate annuity is that the payments are fixed. They do not increase with inflation. While some inflation indexed annuities are available, they have lower initial payouts. An immediate annuity also works best for IRA owners who have no beneficiary to whom to leave their IRA since the payments cease upon the death of the IRA owner (or the death of the survivor of the IRA owner and his/her spouse, if a joint and survivor annuity is purchased). A recent development for retirement annuities is the qualifying longevity annuity contract (QLAC). On July 1, 2014, the IRS released final regulations that make QLACs (first introduced in 2012) more attractive. The QLAC is a close cousin to the immediate annuity. The basic concept of a QLAC is simple: rather than purchasing an immediate annuity in your IRA at age 65 to start receiving income right away, you purchase an annuity for an income stream that will start if and when you reach age 85. Of course, if a 65-year-old wants to have income start at age 85, this conflicts with the RMD rules which require that distributions commence at age 70 ½. The new regulations solve this problem by excluding the value of the QLAC from the account balance used to calculate the RMD. In other words, a QLAC automatically complies with the RMD rules even though payments will start well after age 70 ½. Payments from a QLAC must begin no later than the first day of the month after the participant turns age 85. While the QLAC may have a cost-of-living adjustment, it cannot be a variable or equity-indexed contract, and it cannot offer any cash surrender value. In addition, the amount you re allowed to invest in a QLAC is limited to the lesser of 25% of the IRA balance, or $125,000. The regulations also allow a QLAC to pay benefits in the event the participant dies before reaching the age that payments start. In such event, the payments can be made to a named beneficiary (such as the participant s spouse), or a return of premium death benefit can refund the premiums paid upon the participant s death. However, choosing these options will reduce the amount of retirement income the participant would receive if he/ she lives to the age the income begins. Just like other investments good and bad annuities have fees and expenses. These costs include commissions paid to the salesperson, mortality and expense insurance charges (i.e., the fee the carrier charges for guaranteed death benefits and guaranteed income for life), investment management fees (similar to management fees on mutual funds), and surrender charges for early withdrawals (typically between 5% - 10%). These fees and expenses mean that annuities are not meant for the short-term investor. But, these fees and expenses may be well worth the added costs if the participant s situation and planning needs warrant a rider that provides guaranteed income and/or a guaranteed death benefit. To preserve the tax deferral when using IRA assets to purchase an annuity, you have two choices. The first is to withdraw the money from the IRA and roll it over (within 60 days) to the individual retirement annuity. The other is to do a trustee-to-trustee rollover, whereby the assets are transferred straight from the IRA to the annuity. Finally, when having an IRA own an annuity, keep in mind that the annuity must be valued for Roth IRA conversions and RMDs. The reported value of the annuity may not be the appropriate number. The reason is that riders guaranteeing a death benefit, current income, and/or a guaranteed base of income in the future have value. These features must be considered in valuing the annuity for purposes of a Roth conversion or RMDs. The best course of action is to ask the carrier for the value of the annuity before making a Roth conversion or taking an RMD. This newsletter is designed to provide accurate (at the time of printing) and authoritative information with regard to the subject matter covered. It must not be used as the basis for legal or tax advice. In specific cases, the parties involved must always seek out and rely on the counsel of their own advisors. Thus, responsibility for modifying and guiding any party s action with respect to legal and tax matters is placed where it belongs - with his or her own advisors.