The home is the jewel of the assets, the dream of most people. It is the prize of the family and treated with great respect in most of our laws. So, how does a Living Trust and Estate Planning fit in with home ownership you ask? Answer: In more ways than you are more than certainly aware. Using law and some creative strategies, we can design some asset protection and tax planning for the home.

Protection from whom?

1. Courts

2. Creditors

3. Tax Authorities

4. In laws

5. Lawsuits

6. Medi-Cal claims

Tax planning for what?

1. Capital gains tax

2. Estate tax

3. Reassessed property tax

By what means?

The Living Trust and Estate Planning. Lets get started.

The Living Trust does not protect the owner from lawsuits and creditors. Why? Because an owner continues to own the home after it is transferred to the Trust. Whatever is owned, creditors can reach. So, how is asset protection employed as a benefit and how is the Trust utilized? With the utilization of an Irrevocable Trust created in the Living Trust which we will discuss later.

So what is the first step in Estate Planning for the home? Get it out of a Court’s authority and control. How? Transfer title of the home to a Living Trust. So, first we create the Trust document which must be valid under California law. Then we create a valid deed to transfer title. Also, we prepare transfer documents for the Assessor’s office so that it will be exempt from property tax reassessment. These documents must be filed with the deed. Once this has been completed we have removed the home from California Probate and may be left to beneficiaries without the Court process.

So, what is Probate you ask? It is a Court proceeding that transfers a Decedent’s assets to beneficiaries after statutory fees have been assessed and the Court has issued an order. The problems are based in the fact that obtaining a Court order takes time and the statutory fees are burdensome. Let me ask you a question. How many of you like standing in long lines and subsequently being overcharged! Do you look for the longest line at the grocery store and relish occasionally being charged more than you should for the groceries you purchased? If not, liken this to California Probate. Your beneficiaries are waiting, on average, a year and a half. How many beneficiaries enjoy hearing, “Your check is in the mail but it will take 1 ½ years to receive it”?

If that is not bad enough, take a gander at that statutory fee statement issued by the Court. Let’s use an example:

So the home is valued at $800,00.00 but there is a mortgage of $400,00.00. That means the bank, not your estate owns half of the home. So, how much will the statutory fees be assessed against, $400,000.00 right? You’re dreaming so wake up to the nightmare. Statutory fees in California are assessed against the gross value of the estate, the fair market value, f.mv., of the home or $800,000.00. That’s right. Estates in California pay statutory fees on debt. That’s what I call overcharging. So, it’s up to you. If you like waiting in long lines and being overcharged, elect Probate for your estate. But just be glad you are dead so you don’t have to face the wrath of your beneficiaries.

The California legislation did not do the homeowner any favors in protecting the home from creditors. Unlike some states, like Texas and Florida, that provide 100% protection of the home from creditors, California only allows very limited protection. Basically, the law protects equity between $313,2200.00 and $626,400.00 based on the law adopted in 2021. It would depend upon the median sales price for a single family home in the calendar year prior to the year the exemption is being claimed. There are exceptions to this exemption.

1) If the home is used as collateral for the home loan the lender retains the right to foreclose;

2) The State law exemption does not protect the home from federal claims, most notably the IRS; and

3) If the homeowner chooses to voluntarily sell their home the homestead exemption does not apply to a judgment creditor. It only applies to a forced sell by the creditor. However, there are a couple of provisions that may be included in the Living Trust to protect from creditors of your beneficiaries- The Spendthrift Clause and the No Contest Clause.

1. Spendthrift Clause: This clause should be included in all Living Trusts to prevent beneficiaries from using their potential inheritance as collateral on loans. Essentially and simply, they give notice to a creditor that no property in the Living Trust is to be owned by a beneficiary until the actual distribution to the beneficiary at that no Trust assets may be subject to their debts.

2. No Contest Clause: This clause would prevent a beneficiary’s creditor from suing or contesting a Trust provision like the Spendthrift Clause based on a lack of prudent or reasonable basis to legally contest the Trust or its provisions.

Significant protection the Living Trust can provide in California for the home is protection from Medi-Cal claims. It is a very important law that has become overlooked by the public.

If a family member is stricken with a catastrophic illness that depletes the estate to the minimum allowed by law and qualification for Medi-Cal is arranged, it is imperative that the home be transferred to a Living Trust. If not and the home is subject to Probate, the state becomes a creditor of the estate and may enforce a Medi-Cal claim for reimbursement against the home forcing its sale. But if the home is a Trust asset and avoids Probate, the state of California has no authority to enforce its claim against the home or any other asset in the Trust.

Never give your home to a child who is not going to claim it as a primary residence. If you do the child is potentially going to receive a double-barrel shotgun shell of taxes.

Property Tax: Let’s talk about the home and property tax reassessment. When there is a transfer of the home, either by gift or sale, the property will be reassessed for property taxes with one major exception. Since Prop. 19 was adopted in 2021, all real property transferred to a child may be reassessed unless it meets the following requirements:

1. The Living Trust should specify the bequest to the child;

2. The real property was the primary residence of the parent(s);

3. The same property must be claimed by the child as his/her primary residence;

4. The exemption from reassessment is limited to $1,000,000.00. As a result, we deduct the parent’s tax base value from the current fair market value of the home. Any excess over the $1,000,000.00 exemption is added to the tax base value. For example, if the parent’s tax base value is $400,000.00 and the current fair market value is $1,500,000.00, $100,000.00 will be added to the previous tax base of $400,000.00 for a new reassessment value of $500,000.00. The tax base value is found on the Assessor’s annual tax statement.

5. The child must file for a homestead declaration within one year of the transfer.

Other than that, there is a 2% annual limit on the assessed value based on Prop. 13.

Capital Gains Tax: The real culprit of the taxes on homes is capital gain. Capital gain is realized on the sale of the home. When a home is gifted, it usually creates a gift tax issue but normally does not result in an out-of-pocket tax payment. Anygift tax will merely reduce your exemption from the uniform estate and gift tax exemption currently valued at $13.61 Million Dollars per person.

So, how may we reduce or negate capital gains tax on the sale of the home? We apply the requirements of the Internal Revenue Code §121 that allows an exclusion of $250,000.00 if you are single, or $500,000.00 if you are married, from the capital gains tax. To qualify, you must both own the home and reside in it as your primary residence for 24 months of he last five years prior to the date of sale. You may have rented the home during this five year period, which is fine, as long as you resided in the home for an accumulation of 24 months.

How can you create a major tax problem for your child if you gift your home to them prior to your death?

Carry-Over Basis: Your basis in your home is its original cost, plus improvements you have made on the home over the years. The capital gain results from the value of appreciation over the value of the basis. Thus, if a home who has a basis of $500,000.00 and is sold for $1,000,000.00, we realize a gain of $500,000.00. This amount is subject to capital gains tax. If a couple qualifies under Internal Revenue Code §121, they will pay zero capital gains tax. If it is a single person, they would be subject to capital gains tax on $250,000.00.

But, what if the parent merely gifts the home to a child? Yes, there is a transfer of ownership but since there was no sale, there is no realization of capital gain. So, what is the tax effect? The child receives the parent’s basis in the home, known as a “carry-over basis”. As a result, if the child subsequently sells the home, the child will be subject to capital gain and the real possibility of tax. If the parent leaves the home to the child at the parent’s death, the capital gain, under current law, vanishes. This is called a “step-up in basis” to current fair market value. In simple language, the value of the old cost basis plus improvements on the home moves up to the fair market value of the home at date of death of the parent. If the child then sells the home, since the basis now equals fair market value, there is no capital gain to tax.

*In 2020 and early 2021, many homeowners gifted their homes to children in an effort to avoid the effects of Prop. 19. As a result, the children may have avoided property tax reassessment on the real properties transferred, but received the “carry-over” basis from their parents for capital gain.

Estate Tax: When a couple’s estate may be subject to federal estate tax that includes the home, special consideration must be utilized for capital gains tax advantages. If the Trust estate is divided on the death of the first spouse, assets are normally allocated to an A or B Trust. The A Trust is usually designated as the Survivor’s Trust and the B Trust is designated as the Decedent’s Trust. Under current law in California, the home will receive a step-up in basis, eliminating capital gain, on the death of the first spouse if it was considered community property. There is a presumption that it was so held if transferred to a marital Trust without reservations. To make clear it is held as community property, that designation may be indicated on the transfer deed, or the home may be included in a community property agreement.

So, on the death of the first spouse, should we allocate the home to Trust A or B? It depends on the intentions of the parties and objectives for tax and asset protection.

Trust A: If we allocate the home to Trust A, the surviving spouse will own the home for all purposes. As a result, the home will be entitled to a second step-up in basis on the death of the surviving spouse again eliminating capital gain for the heirs. This is important especially if the surviving spouse lives for a number of years after the first deceased spouse and the home appreciates in value. However, there is no asset protection for the home if the surviving spouse re-marries or is sued.

Trust B: If the home is distributed to Trust B, it will obtain asset protection from claims but it will not obtain a 2nd step-up in basis to negate capital gains tax for appreciation on the death of the surviving spouse. This is because the value of the home will not be included in the estate of the surviving spouse. This can be arranged with a QTIP Trust discussed later. Although Trust B provisions may give the surviving spouse the right to live in and occupy the home and even sell the home, Trust B is the owner of the home, which is an Irrevocable Trust.

Property Reassessment Tax: If the home is not going to be distributed to a child or a specific beneficiary, it should be put up for sale as soon as reasonably possible. The home will be reassessed based on its current fair market value and the taxes will be allocated between the buyer and the seller based on the time period of ownership. Thus, if the Trustee holds the property in Trust for six months prior to the sale, the Trust estate will be responsible for the reassessed taxes for six months. If the home has appreciated 5 to 10 times its’ original value, the reassessment may be onerous.

As previously indicated, the home may be distributed to Trust B for asset protection purposes during the life of the surviving spouse. The surviving spouse may live in the home for the duration of their lifetime and enjoy its benefits even if owned by the irrevocable Trust B. Whether owned by Trust A or Trust B, on the death of the surviving spouse, the home may be transferred to a child via Protective Inheritance Trust (PIT) provisions which provide asset protection for the beneficiary. It is very important that the bequest of the home to a child be specified in the Living Trust.

On the death of the surviving spouse, if the child is involved in any legal proceedings, the home remains in the parent’s Living Trust protected from such proceedings. Once the issues in the proceedings are satisfied, the home is transferred to a Sole and Separate Property Trust arranged for the child which is intended to keep it separate from any marital assets if the child is married, or subsequently marries. If the home or the sales proceeds of the home remain in the Sole and Separate Property Trust of the child, the spouse of the child will have no claim to the original asset and no claim to any appreciation if agreed to in a spousal agreement such as a pre-nuptial or acknowledgment agreement.

What if the child wishes to make some provision for their spouse in the home, but ensure the home is eventually owned by their children on the death of the spouse? The child may amend the Sole and Separate Property Trust to allow for an occupancy provision for the spouse should the child be the first deceased in their marriage. We also create these provisions in blended families when one spouse enters a re-marriage and owns a home.

Occupancy Provision: These provisions allow the non-owning spouse the right to the enjoyment of the home during the earlier of their lifetime or permanent vacancy of the home should the spouse who owns the home be the first deceased. When an occupancy provision is implemented, there must be included additional details of who will be responsible for:

1. Any existing mortgage payments;

2. Property Taxes;

3. Insurance;

4. Maintenance and upkeep;

5. Home Owner’s Association fees (if applicable).

If these specifics are not included it can lead to contests between the surviving spouse and children of the deceased spouse. Actually, this is an area of consistent conflict and legal proceedings when these issues are not included with clarity.

The QTIP Trust is an additional irrevocable Trust we may include under certain circumstances. It is usually used as a strategy to address federal estate tax, especially if one spouse is wealthier than the other, but it also may be utilized for the home. QTIP is the acronym for Qualified Terminal Interest Property. The Trust must provide all income or benefits generated be provided to the surviving spouse and no principal may benefit anyone other than the surviving spouse during their lifetime. On the death of the surviving spouse, the then-value of the QTIP is included in the estate of the surviving spouse which is significant. This is because the home and any other appreciating asset in the QTIP will receive a step-up in basis and eliminate capital gain, unlike Trust B. Thus the QTIP has achieved the following:

1. Provided asset protection during the life of the surviving spouse since the home was owned by an irrevocable Trust;

2. Allowed the home a step-up in basis to wipe out capital gain;

3. Provided ultimate distribution of the home to only a child or children of the first deceased spouse in a blended family. This will preserve ownership for the family to retain or sell the home depending on the family objectives.

The home is an asset that must be included in planning for taxes, asset protection, and inheritance. As a result, special and detailed provisions should be included in the Living Trust and Estate Plan to utilize strategies in this regard and assure objectives are satisfied for the family. After all, it is the prize and jewel of the Estate Plan.