Using a Trust To Protect a Homestead

April 13, 2006

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When considering the role of the homestead exemption in an overall asset exemption plan, you have many options. But the homestead should never be contributed to a business entity, such as a corporation, LLC or partnership. Asset exemptions are available only to natural persons, and not to business entities.

In contrast, transfers of a home to a revocable living trust ordinarily should not create this same problem. Such transfers are common estate planning tools where the goal is to avoid probate court.

In tax cases, the courts have already ruled that, after a transfer to a revocable living trust, the individual can still claim the personal exclusion of the first $250,000 of gain from the sale of a residence, as if it were still owned by the taxpayer personally. In a revocable living trust, the trustor (trust creator) can cancel or amend the trust at will, and the trustor is usually also the trustee and the beneficiary. Thus, the trustor still has complete control over the property.

While there is no guarantee, this same reasoning should extend to asset exemption cases.

However, there is one situation where transfers to a revocable living trust require special attention. In many cases, this type of trust takes the form of an estate-tax-saving bypass or "credit-shelter" trust. Here, a married couple transfers assets to the trust. While both are living, the trust is revocable.

When the first spouse dies, that spouse's share of the trust assets flow into a new, irrevocable trust, under which those assets are managed for the surviving spouse. The survivor has limited powers with respect to the new trust's assets and therefore will escape estate tax on those assets when he or she eventually dies.

The surviving spouse may not be able to claim any exemptions in the assets in the irrevocable trust. The irrevocable trust will be recognized as a separate entity and, in fact, will pay its own income taxes, according to a separate schedule for trusts and estates.

This is especially important to understand because, in many cases, an interest in a home, IRA or other exempt asset may have been contributed to the irrevocable trust. Exemptions would have continued to be available for these interests, had the transfers been outright to the surviving spouse. The bottom line: The exemptions will likely be lost. However, protection may still exist, through a different strategy.

Specifically, this type of trust can immunize trust assets from the claims of creditors through a spendthrift clause. While in certain circumstances this type of clause can be invalid, in the case of the irrevocable trust described here, it should be valid (see our discussion on asset protection trusts).

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If you have a bypass trust and are unsure whether the trust contains an effective spendthrift clause, ask an estate planning attorney to review the document.