Funding a bypass trust with your personal residence if legally permissible. But there are some drawbacks of which you need to be aware. If you have other options, you may want to reconsider.
Funding a bypass trust with your personal residence is perfectly permissible. But since a bypass trust is irrevocable, you lose some control over your residence. Also, once you place your residence into a bypass trust, it loses the $250,000 capital gain exclusion in Internal Revenue Code § 121.
This article will help you understand what a bypass trust is, when funding a bypass trust with a personal residence may be necessary, and what are the consequences of funding your bypass trust with a personal residence. Finally, this article will conclude by showing you two ways to eliminate your bypass trust, if you no longer need it.
What is a Bypass Trust?
A bypass trust is a special sub-trust in a married persons’ estate plan that goes into effect when the first spouse dies. It is sometimes called the “credit trust,” the “credit shelter trust,” or the “B-Trust.”
Whether or not you have a bypass trust depends on the type of trust you created (or your estate planner created for you).
For example, if your estate planner told you that you have an “ABC Trust” then you have a bypass trust.
If your estate planner told you that you have an “AB Trust” then you have a bypass trust.
Additionally, if you have a “disclaimer trust” then you may have a bypass trust. The way a disclaimer trust works is that the surviving spouse can disclaim any part or all of the estate. You would do this to take advantage of the estate exemption. If the surviving spouse disclaims a portion of the estate, then the disclaimed portion goes into a bypass trust.
To understand the bypass trust, you need to know how estate taxes work.
The Basic Exclusion.
The IRS imposes estate taxes or “death taxes” on every estate. But not all estates need to pay the tax. The IRS provides a basic exclusion. This “exclusion” is the amount of your estate that is excluded from the estate tax.
Currently the basic exclusion is $11,580,000. This means that you can transfer up to $11,580,000 to your family tax-free. If you want more information on the basic exclusion, see the IRS publication HERE.
If you are married, each spouse gets to transfer up to $11,580,000. This means that a married couple can transfer $23,160,000 tax-free if they have a bypass trust.
When Do You Need a Bypass Trust
A bypass trust is designed to hold the deceased spouse’s share of the basic exclusion. Without a bypass trust, the entire estate of the deceased spouse (including the exempt estate) would pass tax-free to the surviving spouse.
That sounds like a good thing, but in some cases, it is not. The surviving spouse can only transfer up to the amount of the basic exclusion tax-free, which in 2020 means $11,580,000. So if there is no bypass trust, then you lose the deceased spouse’s entire basic exclusion.
A bypass trust holds the deceased spouse’s basic exclusion. That way you do not lose the basic exclusion for the deceased spouse.
For example, suppose you and married and have an estate worth $25,000,000. Your spouse dies in 2020. Based on the basic exclusion, your spouse can transfer $11,580,000 tax-free.
So, you have two options. First, you can take the $11,580,000 for yourself. Second, you can allocate your deceased spouse’s basic exclusion to a bypass trust.
If you take your spouses share for yourself, it becomes part of your estate. Therefore, if you die, you can only transfer your exempt share (which in 2020 is $11,580,000) to your kids tax-free. Thus, on your death, your children would pay taxes on $13,420,000, which turns out to be approximately $5,368,000.
Instead, if you transferred your deceased spouse’s exempt property to the bypass trust, then you preserve his/her $11,580,000 exemption. As a result, on your death, you can transfer $23,160,000 to your kids tax-free. They would only pay tax on $1,840,000, which is approximately $736,000.
So in this example, by making the initial allocation to the bypass trust, you saved $4,632,000 in taxes.
When You Might Have to Put Your Personal Residence into the Bypass Trust
Now that the individual exemptions are so high, it is hard to imagine a scenario where an estate would be forced to put a personal residence into a bypass trust. In most estates, the family home is the most valuable asset in the estate portfolio.
Thus, suppose your family owns a generational type home worth $25,000,000. It is the only valuable asset in the estate.
If this is the case, then to fund the bypass trust, you will need to put a portion of the home into the bypass trust.
You can avoid this by funding the bypass trust with a promissory note. See our previous article called “How to Fund a Bypass Trust with a Promissory Note” for more information.
Assets in a bypass trust are not taxed at the death of the surviving spouse for estate tax purposes even if the asset appreciates beyond the annual exclusion. Therefore, another situation might be that you decide to put the private residence into the bypass trust because you believe it will appreciate faster than the other estate assets. As a result, you want to take advantage of the appreciating asset.
Risks and Disadvantages of Funding the Bypass Trust with a Personal Residence.
Generally, when someone sells a personal residence, they can take advantage of the Internal Revenue Code’s exclusion for capital gains taxes. Single Persons can sell a personal residence and keep $250,000 tax-free. Married persons can keep $500,000.[i]
But, if you put your personal residence into the bypass trust, does it remain your personal residence for purposes of IRC § 121? No.
The IRS considered this exact scenario in Treasury Opinion 200104005.
In that case, the husband and wife had a living trust with a bypass trust on the death of the first spouse. The wife died first. The husband funded the bypass trust with the personal residence. The bypass trust stated that the husband could live in the home or sell the house whenever he wished.
30-years later, the husband needed to go to an assisted living facility. He sold the home to cover the costs.
The IRS ruled that he could not take advantage of IRC § 121 because he no longer owned the residence. Instead, the bypass trust owned the house. Therefore, the husband paid extra taxes on $250,000 that would have otherwise passed to the husband tax-free.
Another disadvantage of putting your personal residence into the bypass trust is the lack of control. Although the language of the bypass trust often allows the surviving spouse to receive income and (some) principal form the bypass trust, the survivor lacks complete control.
For most people, the lack of control will not really matter. In the example above, the surviving husband had no problems for 30-years. But for some people, the lack of total control over your own house is highly concerning. If this is you, DO NOT fund your bypass trust with your home.
How to Get Out of an Unneeded Bypass Trust.
Since the exclusion amounts doubled in 2017, many people have bypass trusts who no longer need a bypass trust. For example, if you funded a bypass trust ten years ago when the exemption was only $1,000,000, then you may not need the bypass trust, now that the exemption is $11,580,000.
Alternatively, if you had your trust drafted in 2010, it may be completely irrelevant and out of date in 2020.
If you fit into these categories, then there are three ways you can change your bypass trust.
1. If the trust is still revocable (both spouses are still alive and have capacity), then you can amend your trust.
2. If your trust is irrevocable and the bypass trust is already in effect, you can amend the trust with the written consent of all the beneficiaries.
3. You can petition the probate court to reform your trust to reflect current tax law.
If your trust is irrevocable, I would recommend doing both 2 & 3. You want the beneficiaries to consent to protect you from liability. You want court approval to isolate you from liability even further.
If you already have the consent of the beneficiaries, you can either file a petition for instruction or a petition to terminate and amend the bypass trust.
When I have clients in this circumstance, I typically get the approval of all the beneficiaries and then seek court approval to terminate the bypass trust and amend the trust in its entirety to something that makes more sense from a tax perspective.
As always, these are very complicated situations. Making any single mistake can cost millions of dollars. Therefore, always seek competent help when deciding on what to do.
[i] Internal Revenue Code § 121.