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Wealth Planning News

Vol. IV, No. 8

Residence in Trust Problem

Where a complex trust, as described below, owns a residence used by the beneficiary, the residence is not a personal residence of the beneficiary for income tax purposes.

That means the mortgage interest deduction is not available to the beneficiary on a personal income tax return. Even worse, the ability to shelter up to $250,000 of gain on sale of a personal residence ($500,000 for a married couple) is lost.

These benefits to homeowners are important and are lost when a personal residence is owned in a complex trust.

Nearly all "Family Trusts" or "Bypass Trusts" or "Credit Shleter Trusts" (different names for a trust created when a person dies and puts assets into a trust for spouse, which trust does not qualify as a marital deduction trust) are complex trusts. Ongoing trusts for descendants are complex trusts if such trusts are not compelled to distribute all trust income to a beneficiary. So most protective trusts for loved ones, including so-called "Dynasty Trusts" are complex trusts.

Complex trusts should not own the personal residence of a trust beneficiary.

A Complex Trust


For income tax purposes think of a complex trust as one that is not a grantor trust, one that must file its own trust income tax return.


Unlike a grantor trust, which is what a revocable living trust is before the trustmaker dies, a complex trust has its own tax identification number and has to pay income taxes.


A complex trust quickly reaches the maximum income tax rates because Congress and the IRS just hate to allow trusts to be taxpayers that split income with beneficiaries, resulting in each taxpayer, the trust and the individual, being in a low rate as a result of lower separate income than if all of it were bunched on one taxpayer. 

But a complex trust receives an income tax deduction on the trust's income tax return for trust income that is distributed to a beneficiary of the trust. The beneficiary, in turn, must then report that income distribution received from the trust, on the personal income tax return of the beneficiary. In this way the beneficiary can avoid the higher income tax rates on trust income, and shift the income to the personal tax rate of the beneficiary.

Solution: Buy the Residence


A beneficiary must buy the beneficiary's personal residence from the complex trust. Sales proceeds go into the trust for the beneficiary. The income tax effect on the trust is nil if the sales price is equal to the appraised date of death value of the decedent who owned the property. Therefore, although the sale is a taxable event for the trust, it results in no gain that is taxed.

Beneficiary Lacks Funds

A problem arises where the trust beneficiary lacks sufficient personal funds to buy the residence from his or her trust. Here is how to solve the problem:

The trust sells the residence to the beneficiary. The beneficiary pays for the residence with a promissory note drawing reasonable interest as required by the IRS. The note is secured by a first priority mortgage on the residence.

The beneficiary now has to make monthly payments of interest and principal to the trust. Funds to make the first payment come from personal funds of the beneficiary, or if these funds are inadequate, the first payment comes from a distribution from the trust to the beneficiary for living needs. (Distributions are normally allowed under what is called HEMS standard, meaning for health, education, maintenance or support of the beneficiary.)

After the beneficiary makes each note payment, the trust distributes an amount (it could be equal to the payment received by the trust) back to the beneficiary for living needs. Now the beneficiary has funds on hand to make the next note payments coming due.

Tax Effects Zero

The interest portion of each note payment is deductible by the beneficiary who makes the payment, on the beneficiary's personal income tax return. 


The interest portion of each note payment to the trust is taxable income to the trust. But remember that the trust is making distributions each month to the beneficiary. Part of each distribution to the beneficiary is interest income received by the trust. So the trust gets an income tax deduction on its income tax return for income distributed to the beneficiary.


The beneficiary now must report the interest income distributed to the beneficiary by the trust, on the beneficiary's personal income tax return. But remember the interest deduction the beneficiary received when he made the mortgage payment on a personal residence? It exactly offsets the interest income of the beneficiary resulting from interest on the note that is distributed back to the beneficiary.


The tax result is zero for the trust and zero for the beneficiary. Over time the note is paid off and the residence ends up personally owned by the beneficiary.


The effect of this transaction on the trust estate is also zero, since the trust distributes to the beneficiary an equal amount to what the beneficiary puts back into the trust.


The trust principal remains subject to some strong protection against potential lawsuits and divorces. In fact, this technique can be used to give asset protection to a personal residence of a beneficiary who lives in a state where there is little meaningful homestead exemption available. In that situation, the smart thing to do is to keep a personal residence fully encumbered.

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Copyright 2022 Hopp & Associates, PC

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