Part 2 discusses additional tax and non-tax reasons why putting your personal residence in an irrevocable trust (that is not a QPRT) is bad planning.
Loss of basis step up on death ~ Since Arizona is a community property state, assets held and/or titled as community property receive a full step up (down) in basis to the fair market value on date of death. The trust takes the parents’ basis in the house (i.e. their initial purchase price plus improvements). Had the home not been transferred to the trust, it would have received a new basis at fair market value on the date of the parents’ death, thereby wiping out any gain that the trust will have.
Creditor Protection? Probably not ~ Creditor protection is a valid reason for setting up an irrevocable trust. However, what many individuals are not aware of is that creditor protection only protects future beneficiaries and not the grantors. Recent court cases show courts are regularly attacking and invalidating trusts set up for asset protection and are requiring trust assets be used to satisfy creditors claims. Moreover, the trust terms allow the son as trustee to distribute all the assets in the trust back to his parents. Based on this broad provision, if his parents were to get sued, it is probable that this trust provides no creditor protection whatsoever. Thus, the parents’ sense of security this trust provides as to creditor protection is illusory.
Takeaways ~ Given the parents’ net worth and personal income tax situation, this irrevocable trust was not appropriate or needed, and they are not gaining anything. They are losing personal income tax deductions, capital gains exclusions and loss of basis step up on death. Moreover, the trust will likely not shield their residence or other assets transferred to it from potential creditors. Trust decanting is likely a potential fix.
Seek out competent legal advice and, before establishing an irrevocable trust, get your other advisers (especially your tax adviser) involved to see if the added complexity and cost is justified.
By Jennie Ward