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The Revocable Living Trust

The Revocable Living Trust
A revocable living trust is a trust that can be revoked or canceled at any time by the settlor. The term “living trust” means simply that the trust is established during the lifetime of the settlor. (Testamentary trusts, those created upon the settlor’s death, do not avoid probate and are not nearly as popular today as they once were.) During the past ten or fifteen years, revocable living trusts have gained enormous popularity as a sound technique for accomplishing a number of legitimate estate planning goals.

Funding the Trust
For the revocable trust to be effective in eliminating probate, it is essential that all family assets be transferred into the trust prior to a spouse’s death. Any property that has not been transferred into the trust will be subject to probate, defeating the purpose of creating it in the first place. An amazing number of people go to the trouble and expense of forming a revocable trust and then fail to complete the work necessary to fund it.

Funding the trust involves transferring legal title from husband and wife into the name of the trust. For example, if Harry and Martha Jones are funding their revocable trust, they will change title to their assets from “Harry Jones and Martha Jones, husband and wife” to “Harry Jones and Martha Jones as Trustees of the Jones Family Trust, Dated January 1, 1999.”

For real estate, the change in title is accomplished by executing and recording a deed to the property. Bank accounts and brokerage accounts can be transferred by simply changing the name on the accounts to reflect the trust as the new owner. Shares of stock and bonds in registered form are changed by notifying the transfer agent for the issuing company and requesting that the certificates be reissued in the name of the trust. Stock in a family owned corporation can be changed by endorsing the old stock certificate to the trust and having the corporation issue a new certificate to the trust. Other types of property can be transferred by a simple written declaration called an Assignment.

The living trust also can be funded indirectly by transferring interests in other entities. For example, if you hold your property in a Family Limited Partnership or Limited Liability Company, the living trust can hold your shares in those companies.

Asset Protection
A revocable trust does not provide any protection of assets from judgment creditors. It is ignored for creditor purposes just as it is ignored for income tax purposes. In most states, the law provides that if a settlor has the right to revoke the trust, all of the assets are treated as owned by the settlor. Perhaps because of the promotion associated with these trusts, many people mistakenly believe that a revocable trust somehow shields assets from creditors. This is not correct. If there is a judgment against you, the creditor is entitled to seize any assets that you have in the trust. Asset protection can be accomplished when property is held in the FLP or LLC and those interests are owned by the trust.

Community Property
In community property states, each spouse’s interest in the community property is subject to the claims of the other spouse’s creditors. If there is a judgment against the husband, all community property assets held by husband and wife are available to satisfy the judgment. On the other hand, the separate property of a spouse will generally not be subject to the claims of the creditors of the other spouse.

These rules provide some obvious opportunities to achieve a measure of asset protection. If community property is divided into equal shares of separate property of the husband and separate property of the wife, those separate property interests will not be available to satisfy the claims of the other spouse’s creditor. Generally, a living trust would be created for each spouse—for the estate planning benefits and to confirm that the marital property has been divided. Those in community property states can at least limit their potential exposure to a creditor’s claim to one-half of the marital property, rather than all of the marital property, by creating this type of division.

The primary drawback of this technique is that a division of community property into separate property trusts may be disadvantageous from an income tax standpoint. All property held as community property receives a stepped-up basis on the death of the first spouse. For example, a husband and wife buy a property during their marriage for $50,000 that is later worth $100,000. If they sell the property, they will have a gain of $50,000 and will pay taxes on that amount. Suppose that instead of selling, the property is held until the time the first spouse dies. All community property now receives a new tax basis equal to its value as of the date of death—$100,000 in this example. Therefore, if the property is held until the death of the first spouse, all taxable gain is eliminated.

This favorable situation does not occur when a husband and wife hold separate property. In this situation, only the deceased spouse’s interest in the property receives the stepped-up basis. In the above example, if the property were held one-half each by Husband and Wife, only the interest of the deceased spouse would receive the new basis. This would result in a $75,000 basis, and a $25,000 gain, if the surviving spouse sold the property for $100,000.

If you hold community property that has substantially appreciated in value, it probably would not be advisable to divide the property into separate shares and thereby lose out on the significant tax savings that can otherwise be achieved. Alternative methods of asset protection should be explored.

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