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George F. Bearup, J.D. Senior Legal Trust Advisor

9-May-18

Cottage Held in an Irrevocable Trust

Take-Away: With the new limits on the income tax deductibility of state and local taxes, in particular real property taxes,  new strategies are now  beginning to emerge to deal with that income tax deduction limitation. One strategy is to shift the real property tax burden to an irrevocable trust, which has its own $10,000 annual state and local tax limitation on the property tax deductions. Accordingly, it might make sense to retitle a residence in the name of an irrevocable trust (along with other income producing assets) in order for the trust to be obligated to pay the real property taxes associated with that dwelling, and thus also be able to claim the income tax deduction for the real property taxes the trust must pay. However, there could be some unintended consequences if a trust holds title to a residence, including an uncapping of its taxable value if non-close-family members are beneficiaries of the trust. An additional problem is that the 2017 Tax Cut Act changes to income tax deductions sunset in 2026, so the owner who transfers the residence to the trust to ‘double up’ on the state and local tax (SALT) deduction has to understand that the title transfer is permanent while the income tax rules the trust is designed to exploit disappear in 7 years.

Background: The income tax deduction for state and local income, sales and property taxes has been limited to $10,000 annually for individual taxpayers for each Form 1040 tax return, including non-grantor trusts and estates. [IRC 164.] This limitation is set to expire beginning in 2026. This dollar limitation also applies to married individuals who file jointly- [is this another marriage penalty?] Nor is this tax deduction limitation indexed for inflation- it is a flat $10,000 per year. With the 2017 Tax Cut Act’s increase in the standard deduction amount ($12,000 individuals, $24,000 married couples, but no standard deduction for an estate or a non-grantor trust) many taxpayers will now use the standard deduction, and thus they may not be able to use all of their tax  deductions that were previously available  to them under the Tax Code. Some income tax  deductions can be bunched, like charitable gifts, into a single year to have their tax deductions exceed the standard deduction amount, but there is not much choice (if penalties and interest are to be avoided) in the ability to bunch several years real property taxes into a single calendar year. If a trust held title to the real estate and thus it was responsible to pay the real property taxes on the real estate it held, it could claim its own state and local tax deduction, up to $10,000 a year.

Strategy: A non-grantor trust is a taxpayer, separate and independent of its settlor and beneficiaries. The non-grantor trust is entitled to deduct up to $10,000 a year for state and local taxes. [IRC 641(b); Reg. 1.641(b)-1.] Consequently, if the trust holds income producing assets as a side-fund, along with title to the real estate, the income generated by the trust’s side fund assets can be used to pay the real property taxes associated with the real estate, and the trust can then deduct, up to $10,000, the real property taxes that it pays in a single calendar year. If the settlor continued to own the real estate there is a good chance not all of the real property taxes associated with the same real estate would be deductible if there were other state and local taxes paid by that individual, such as the real property taxes on their principal dwelling or sales taxes paid on valuable items purchased.

Example: Client owns a large home and an expensive cottage on one of the Great Lakes. Client has real property taxes to pay on both her principal residence and her cottage. She probably has other state income taxes to pay as well. If all those taxes- income, home property taxes, and cottage property taxes, and sales taxes- exceed $10,000 in the year, she is only able to deduct up to $10,000 for the year for all of those taxes, and she cannot deduct the excess above that $10,000 amount as an income tax deduction. If she transfers title to her cottage to an irrevocable trust, maybe a new Michigan asset protection trust, then the trustee will be able to deduct the real property taxes that it pays on the cottage that it holds in the trust up to $10,000, whereas the client may not have been able to claim that SALT deduction due to her other state and local taxes paid. The transfer of the cottage title to the trust would either be a taxable gift, against which her $11.18 million gift tax exemption would apply so no gift taxes are actually paid, or she could make an incomplete gift with the transfer, perhaps by retaining a testamentary limited power of appointment over the trust which holds the title to the cottage.

Caveat: Note that if the client had used a Qualified Personal Residence Trust (QPRT) to hold title to the cottage, this shifting of the real property tax burden for the cottage would not occur. The Qualified Personal Residence Trust is a grantor trust under the Tax Code, and with any grantor trust, all tax attributes, i.e. income, credits, deductions, automatically pass through to the grantor-settlor. Consequently, only a conventional irrevocable trust would be able to claim the $10,000 state and local tax deduction, which is not the case if a QPRT is used to hold title to the cottage.

Drawbacks: There may a be a some drawbacks to transferring title of a residence/cottage to an irrevocable non-grantor trust.

  • Sale: One example is the sale of the residence owned by the trust. Such a sale would not qualify for the gain exclusion under IRC 121 given that the trust, and not its settlor, is treated as the residence owner. [IRC 121 provides for the exclusion of $250,000 ($500,000 for a married couple) of gain recognized upon sale of a taxpayer’s  principal residence if it has been owned and used by the taxpayer for at least 2 of the last 5 years before the sale.] While an individual’s estate or revocable grantor trust may qualify for the home-sale exclusion, that benefit does not extend to a non-grantor trust or to a trust beneficiary who has used the real property as his or her principal residence.[IRC 121(d)(11).] If the sale is contemplated sometime before 2026, then the trust might be initially structured as non-grantor trust, but a trust protector could be given a power to amend the trust to convert it to a grantor trust, e.g. give to the settlor the right to substitute assets with the trust, which would then permit a sale to be subject to the IRC 121 gain exclusion. Or, the trust could be initially structured so that grantor trust status could be toggled on and off by the trustee, with enough time left in order for the settlor-grantor to satisfy minimum 2 year usage rule required by IRC 121. In contrast, if the cottage is treated by the family as an heirloom asset that will never be sold outside the family, the transfer of the title to the cottage to a non-grantor trust may make sense for the long-term estate planning objectives of the family.
  • Estate Inclusion: While the settlor can create an irrevocable trust and continue to use the dwelling now titled in the name of the trust, there is a good chance that the continued use of the dwelling by the settlor, after the lifetime transfer to the trust, will prompt the IRS to claim that the value of the home (and all other trust assets) should be taxed in the settlor’s gross estate at the time of her death. [IRC 2036(a)(1).] This may not be as big a concern if the settlor dies prior to year 2026 while the federal estate tax exemption amount is doubled, but it could present a problem for the settlor if death is after the return to the lower $5.5 million estate tax exemption (after year 2025.)
  • Uncapping the Taxable Value: If non-close-family members, e.g. a nephew or niece, are included in the trust beneficiaries, then it is possible that the taxable value of the cottage will be uncapped when title passes to the non-grantor trust. Thus, the identity of the trust beneficiaries is important to keep in mind to avoid an inadvertent increase in the real property taxes that the trust must pay.
  • Need for Income: For this strategy to work, the grantor/settlor must also transfer income producing assets to the non-grantor trust so that it will have income with which to pay the real property taxes. A substantial amount of income producing assets will have to be transferred so that enough income is generated from them to fully cover the real property taxes, not to mention the administrative costs associated with the irrevocable trust. But for those clients who own trades or businesses, who want to qualify for the ‘new’ IRC 199A business deduction, they may have an incentive to keep their income lower (by shifting some of that passive income to the trust) in order to remain qualified to claim the IRC 199A deduction. The point is that a large gift of income producing assets to the trust will be required for there to be enough income generated to be used to pay the trust’s real property tax bill each year.

Conclusion: If an individual owns non-trade or business real estate, like a cottage, who cannot deduct the real estate taxes paid on the cottage due to the increased standard income tax deduction or absorbing all (or at least a part) of the deduction under IRC 164 because of other state and local taxes paid, she could gift the cottage to an irrevocable (non-grantor) trust for close family members, together with investment assets that are expected to produce income equal to the amount of the real estate taxes associated with the cottage, anticipated not to be more than $10,000 a year. Because the income will be offset by the real estate income tax deduction, the trust should owe no income tax. In effect, the family will have received the benefit of a full income tax deduction for the real estate taxes the trust pays on the cottage, not to mention removing the taxable income from the client who has her own income tax liability. If the estate tax exemption amounts drop in future years back to prior ‘lower’ levels, removing the cottage and its future appreciation from her estate currently may also be an incentive to look at transferring the cottage to the separate trust at this time.

This may also be an appropriate time to consider a substantial lifetime gift since the transfer of title to the cottage to the trust, along with a side fund sufficient to generate up to $10,000 a year in taxable income, are all taxable lifetime gifts, yet the individual now has an additional $5.5+ million federal gift tax exemption to use to avoid paying any gift taxes. If the individual wants to continue to use the cottage after its transfer to the trust, then probably the individual should enter into a formal lease with the trustee, and continue to pay the household expenses associated with the cottage as these other annual expenses, e.g. utilities, homeowner insurance premiums, are not deductible. Perhaps this strategy is overkill when the $10,000 limitation on state and local taxes is supposed to disappear in year 2026, but it may also be one more reason to consider a lifetime gift of the residential real estate (and side fund of income producing investments) for long term estate tax minimization purposes.