using trusts in estate planning

Clients always want to know about trusts: what they are, how they work and why there are so many different names: revocable, living, asset protection, etc. Here we’ll explain what trusts are, what the names mean, and benefits of trusts in estate planning.

Trusts are separate legal entities, in much the same way as corporations and LLCs are. A trust is created by a person referred to as a “grantor” or “settlor.” The trustee oversees the trust, and the “trust agreement” describes how trust assets will be managed and ultimately distributed to “beneficiaries.”

If a trust is created under a will, and only takes effect when someone dies, it’s called a testamentary trust. A trust that is created when someone is alive, and takes effect presently, is known as an inter vivos trust. Some trusts can be changed (“revocable”) and some trusts generally cannot be changed (“irrevocable”). Supplemental needs trusts (not addressed here) are created for disabled persons.

The most common type of trust used in estate planning is known as a living trust, a type of revocable trust. You create a living trust while you are alive, can use all the trust assets as if you still own them and change the trust terms in any way you like. You serve as both grantor and trustee and can appoint a new trustee to take over if you become mentally impaired.

As with all trusts, a living trust (1) avoids probate (non-probate asset), (2) requires no court supervision, (3) preserves the Star benefit if you live in a home owned by the trust, and (4) cannot be used to repay Medicaid after you die, under present law.

An asset is only considered owned by a trust if the account or deed names the trust as the owner. This means a new recorded deed and new name on bank accounts is needed to transfer property to a trust. You remain the legal owner if you fail to change the legal ownership. A living trust uses your social security number and reports income on a schedule filed with your personal tax return.

An irrevocable trust works differently. It has its own tax ID and files its own tax return. When you establish the trust, you appoint the trustee and name beneficiaries. You generally can’t serve as trustee or make material changes. Assets transferred to an irrevocable trust start the five year look back period running, as of the date of transfer. The assets are no longer owned by you, but you can reserve the right to receive (and get taxed on) income from the trust. These irrevocable trusts are also called “asset protection trusts” or “Medicaid income only trusts.”

These trusts also offer a valuable tax benefit known as “stepped up” basis. Here’s how it works: If you make an outright gift of your home to your children, they get your “cost basis” of (for example) $30,000, the price you paid for the home. If they later sell it for $850,000, the built in appreciation ($820,000) incurs capital gains tax of roughly $124,500. If, however, the home is contributed to a trust, your children inherit it with a “stepped up” basis (date of death value) and there is no tax on the built-in gain. Here, if the date of death value is $850,000, roughly $124,500 is saved.

Here, we’ve described the basics about trusts. Make sure you understand the rules to get the results you want if considering a trust as part of your estate planning.

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