Living Trusts Explained

A trust can seem like a mysterious creature, dreamed up by lawyers and wrapped in legal jargon. Trusts were an invention of medieval England, used as a method to evade restrictions on ownership and inheritance of land. Don't let the word "trust" scare you. True, the word can have an impressive, slightly ominous sound. And trusts have traditionally been used by the very wealthy to preserve their riches from generation to generation. (Indeed, isn't one version of the American dream to be the beneficiary of your very own trust fund?) But happily, the types of living trusts this book covers aren't complicated or beyond the reach of ordinary folks. Here are the basics.

The Concept of a Trust

A trust is an intangible legal entity ("legal fiction" might be a more accurate term). You can't see a trust, or touch it, but it does exist. The first step in creating a working trust is to prepare and sign a document called a Declaration of Trust.

Once you create and sign the Declaration of Trust, the trust exists. There must, however, be a flesh-and-blood person actually in charge of this property; that person is called the trustee. With traditional trusts, the trustee manages the property on the behalf of someone else, called the beneficiary. However, with a living trust, until you die, you are the trustee of the trust you create and also, in effect, the beneficiary. Only after your death do the trust beneficiaries you've named in the Declaration of Trust have any rights to your trust property.

Creating a Living Trust

When you create a living trust document with this book, you must identify:

• Yourself, as the grantor -- or for a couple, the grantors. The grantor is the person who creates the trust.
• The trustee, who manages the trust property. You are also the trustee, as long as you (or your spouse, if you make a trust together) are alive.
• The successor trustee, who takes over after you (or you and your spouse) die. This successor trustee turns the trust property over to the trust beneficiaries and performs any other task required by the trust.
• The trust beneficiary or beneficiaries, those who are entitled to receive the trust property at your death.
• The property that is subject to the trust.

A Declaration of Trust also includes other basic terms, such as the authority of the grantor to amend or revoke the document at any time, and the authority of the trustee.

How a Living Trust Works

The key to establishing a living trust to avoid probate is that the grantor -- remember, that's you, the person who sets up the trust -- isn't locked into anything. You can revise, amend, or revoke the trust for any (or no) reason, any time before your death, as long as you're legally competent. And because you appoint yourself as the initial trustee, you can control and use the property as you see fit while you live.

And now for the legal magic of the living trust device. Although a living trust is only a legal fiction during your life, it assumes a very real presence for a brief period after your death. When you die, the living trust can no longer be revoked or altered. It is now irrevocable.

With a trust for a single person, after you die, the person you named in your trust document to be successor trustee takes over. He or she is in charge of transferring the trust property to the family, friends, or charities you named as your trust beneficiaries.

With a trust for a married couple, the surviving spouse manages the trust. A successor trustee takes over after both spouses die.

There is no court or governmental supervision to ensure that your successor trustee complies with the terms of your living trust. That means that a vital element of an effective living trust is naming someone you fully trust as your successor trustee. If there is no person you trust sufficiently to name as successor trustee, a living trust probably isn't for you. You can name a bank, trust company, or other financial institution as successor trustee, but that has serious drawbacks.

After the trust grantor dies, some paperwork is necessary to transfer the trust property to the beneficiaries, such as preparing new ownership documents. But because no probate is necessary for property that was transferred to the living trust, the whole thing can generally be handled within a few weeks, in most cases without a lawyer. No court proceedings or papers are required to terminate the trust. Once the job of getting the property to the beneficiaries is accomplished, the trust just evaporates, by its own terms.

There are a couple of exceptions here. First, a prosperous couple may create what's called an AB living trust to avoid probate and save on overall estate taxes. When one spouse dies, that spouse's trust keeps going until the second spouse dies. A lawyer or other financial expert must be hired to divide the trust property between that owned by the deceased spouse's trust and that owned by the surviving spouse.

Another type of trust that can last for a long time is called a child's trust. The trust forms in this book allow you to create a child's trust if you wish, to leave trust property to one or more minors or young adult beneficiaries. These trusts are managed by your successor trustee and can last until the young beneficiary reaches the age you specified in your Declaration of Trust. Then the beneficiary receives the trust property, and the trust ends.

Probate and Why You Want to Avoid It

Given that you're reading this book, you probably already know that you want to avoid probate. If you still need any persuasion that avoiding probate is desirable, here's a brief look at how the process actually works.

Probate is the legal process that includes:

• filing the deceased person's will with the local probate court (called "surrogate" or "chancery" court in some places)
• taking inventory of the deceased person's property
• having that property appraised
• paying legal debts, including death taxes
• proving the will valid in court, and
• eventually distributing what's left as the will directs.

If the deceased person didn't leave a will, or a will isn't valid, the estate must still undergo probate. The process is called an "intestacy" proceeding, and the property is distributed to the closest relatives as state law dictates.

People who defend the probate system (mostly lawyers, which is surely no surprise) assert that probate prevents fraud in transferring a deceased person's property. In addition, they claim it protects inheritors by promptly resolving claims creditors have against a deceased person's property. In truth, however, most property is transferred within a close circle of family and friends, and very few estates have problems with creditors' claims. In short, most people have no need of these so-called benefits, so probate usually amounts to a lot of time-wasting, expensive mumbo-jumbo of aid to no one but the lawyers involved.

The actual probate functions are essentially clerical and administrative. In the vast majority of probate cases, there's no conflict, no contesting parties -- none of the normal reasons for court proceedings or lawyers' adversarial skills. Likewise, probate doesn't usually call for legal research or lawyers' drafting abilities. Instead, in the normal, uneventful probate proceeding, the family or other heirs of the deceased person provide a copy of the will and other financial information. the attorney's secretary then fills in a small mound of forms and keeps track of filing deadlines and other procedural technicalities. Some lawyers hire probate form preparation companies to do all the real work. In most instances, the existence of these freelance paralegal companies is not disclosed to clients, who assume that lawyers' offices at least do the routine paperwork they are paid so well for. In some states, the attorney makes a couple of routine court appearances; in others, normally the whole procedure is handled by mail.

Because of the complicated paperwork and waiting periods imposed by law, a typical probate takes up to a year or more, often much more. (I once worked in a law office that was profitably entering its seventh year of handling a probate estate -- and a very wealthy estate it was.) During probate, the beneficiaries generally get nothing unless the judge allows the decedent's immediate family a "family allowance." In some states, this allowance is a pittance -- only a few hundred dollars. In others, it can amount to thousands.

Most states now allow simplified probate for certain types of estates. While simplified probate can speed up the process, and may even result in lower attorney fees, the truth is that probate -- simplified or not -- is simply a waste for most people.

Probate usually requires both an "executor" (called a "personal representative" in some states) and someone familiar with probate procedures, normally a probate attorney. The executor is a person appointed in the will who is responsible for supervising the estate, which means making sure that the will is followed. If the person died without a will, the court appoints an "administrator" (whose main qualification may sometimes be that he or she is a crony of the judge) to serve the same function. The executor, who is usually the spouse or a friend of the deceased, hires a probate lawyer to do the paperwork. The executor often hires the decedent's lawyer (who may even have possession of the will), but this is not required. Then the executor does little more than sign where the lawyer directs, wondering why the whole business is taking so long. For these services, the lawyer and the executor are each entitled to a hefty fee from the probate estate. Some lawyers even persuade (or dupe) clients into naming them as executors, enabling the lawyers to hire themselves as probate attorneys and collect two fees -- one as executor, one as probate attorney. By contrast, most relatives and friends who serve as executors do not take the fee, especially if the person who serves is a substantial inheritor.

Probate can evoke images of greedy lawyers consuming most of an estate in fees, while churning out reams of gobbledygook-filled paper as slowly as possible. While there can be some truth in these images, lawyer fees rarely actually devour the entire estate. In many states, the fees are what a court approves as "reasonable." In a few states, the fees are based on a percentage of the estate subject to probate. Either way, probate attorney fees for a routine estate with a gross value of $500,000 (these days, in many urban areas, this may be little more than a modest home, some savings, and a car) can amount to $10,000, $15,000, or more. Fees based on the "gross" probate estate means that debts on property are not deducted to determine value. For example, if a house has a market value of $300,000 with a mortgage balance of $260,000 (net equity of $40,000), the gross value of the house is $300,000.

In addition, there are court costs, appraiser's fees, and other possible expenses. Moreover, if the basic fee is set by statute and there are any "extraordinary" services performed for the estate, the attorney or executor can ask the court for additional fees.

Even England -- the source of our antiquated probate laws -- abolished its elaborate probate system years ago. It survives in this country because it is so lucrative for lawyers.

Avoiding Probate

The most flexible and complete probate-avoidance method is, undoubtedly, the living trust. However, there are a number of other methods.

Informal Probate Avoidance

You may wonder why surviving relatives and friends can't just divide up your property as your will directs (or as you said you wanted, if you never got around to writing a will), and ignore the laws requiring probate. Some small estates are undoubtedly disposed of this way.

For example, say an older man lives his last few years in a nursing home. After his death, his children meet and divide the personal items their father had kept over the years. What little savings he has have long since been put into a joint account with the children anyway, so there's no need for formalities there.

For this type of informal procedure to work, the family must be able to gain possession of all of the deceased's property, agree on how to distribute it, and pay all the creditors. Gaining possession of property isn't difficult when the only property left is personal effects and household items. However, if real estate, securities, bank accounts, cars, boats, or other property bearing legal title papers are involved, informal family property distribution can't work. Title to a house, for example, can't be changed on the say-so of the next of kin. Someone with legal authority must prepare, sign, and record a deed transferring title to the house to the new owners, the inheritors.

Further, whenever outsiders are involved with a deceased's property, do-it-yourself division by inheritors is not feasible. For instance, creditors can be an obstacle; a creditor concerned about being paid can usually file a court action to compel a probate proceeding.

Another stumbling block for an informal family property disposition is disagreement among family members on how to divide the deceased's possessions. All inheritors must agree to the property distribution if probate is bypassed. any inheritor who is unhappy with the result can, like creditors, file for a formal probate. If there's a will, the family will probably follow its provisions. If there is no will, the family may look up and agree to abide by the inheritance rules established by the law of the state where the deceased person lived. Or, in either case, the family may simply agree on their own settlement. For example, if, despite a will provision to the contrary, one sibling wants the furniture and the other wants the tools, they can simply trade.

In sum, informal probate avoidance, even for a small estate, isn't something you can count on. Realistically, you must plan ahead to avoid probate.

Other Probate-Avoidance Methods

Besides the living trust, these are the most popular probate-avoidance methods:

• joint tenancy or tenancy by the entirety
• pay-on-death financial accounts
• transfer-on-death registration for stocks and bonds
• retirement accounts
• life insurance
• state laws that exempt certain (small) amounts of property left by will from probate, and
• gifts made while you are alive.

These methods are discussed briefly in chapter 15.

More on avoiding probate. These and other probate avoidance techniques are discussed in detail in Plan Your Estate, by Denis Clifford and Cora Jordan (Nolo).

While I'm a fan of living trusts, I don't believe they are always the best probate-avoidance device for all property of all people in all situations. It's up to you to determine whether a living trust is the best way for you to avoid probate for all your property, or whether you want to use other methods.

Reducing Estate Taxes

A basic probate-avoidance living trust, either for a single person or a couple, does not, by itself, reduce federal or state estate taxes. The taxing authorities don't care whether or not your property goes through probate; all they care about is how much you owned at your death. Property you leave in a revocable living trust is definitely considered part of your estate for federal estate tax purposes.

Under federal law, the personal estate tax exemption allows a set dollar amount of property to pass tax-free, no matter who it is left to. This amount varies, depending on the year of death, as shown below.

In addition to the personal exemption, all property left to a spouse (if that spouse is a U.S. citizen) or to a tax-exempt charity is exempt from estate tax.

Some specialized kinds of living trusts can save on estate taxes. This book contains two such tax-saving trusts: two types of an AB trust.

If you are a member of a couple with combined property worth over the estate tax threshold, you could save your inheritors substantial estate taxes by using one of Nolo's AB trusts. Couples can shield a combined estate worth between $4 million and $7 million from estate taxes, depending on the years of death. Basically, an AB trust allows each member of a couple to use a separate personal estate tax exemption (that is, use two exemptions in total) while leaving one spouse's property for the use of the surviving spouse. AB trusts are explained in depth in chapters 4 and 5.

When to get expert help. If the combined value of your and your spouse's estates exceeds the estate tax threshold, you'll need estate tax planning help that's beyond the scope of this book, although an AB trust will likely be a key component of your final plan.

Other Advantages of a Living Trust

As you know, the main reason for setting up a revocable living trust is to save your family time and money by avoiding probate and perhaps estate taxes as well. But there are also other advantages. Here is a brief rundown of the other major benefits of a living trust.

Out-of-State Real Estate Doesn't Have to Be Probated in That State

The only thing worse than regular probate is out-of-state probate. Usually, an estate is probated in the probate court of the county where the decedent was living before he or she died. But if the decedent owned real estate in more than one state, it's usually necessary to have a whole separate probate proceeding in each one. That means the surviving relatives must find and hire a lawyer in each state, and pay for multiple probate proceedings.

With a living trust, out-of-state property can normally be transferred to the beneficiaries without probate in that state.

You Can Avoid the Need for a Conservatorship

A living trust can be useful if the person who created it (the grantor) becomes incapable, because of physical or mental illness, of taking care of his or her financial affairs. The person named in the living trust document to take over as trustee at the grantor's death (the successor trustee) can also take over management of the trust if the grantor becomes incapacitated. (See chapter 7.) When a couple sets up a trust, if one person becomes incapacitated, the other takes sole responsibility. If both members of the couple are incapacitated, their successor trustee takes over. The person who takes over has authority to manage all property in the trust, and to use it for the grantor or grantors' benefit.

EXAMPLE: Wei creates a revocable living trust, appointing herself as trustee. The trust document states that if she becomes incapacitated, her daughter Li-Shan will replace her as trustee and manage the trust property for Wei's benefit.

If there is no living trust and no other arrangements have been made for someone to take over property management if you become incapacitated, someone must get legal authority, from a court, to take over. Typically, the spouse or adult child of the person seeks this authority and is called a conservator or guardian. Conservatorship proceedings are intrusive and often expensive, and they get a court involved in your personal finances on a continuing basis.

Your successor trustee has no power to make health care decisions for you if you become incapacitated. If your preference is to die a natural death without the unauthorized use of life support systems, you'll want to prepare and sign health care directives. (This is discussed in chapter 15.)

Your Estate Plan Remains Confidential

When your will is filed with the probate court after you die, it becomes a matter of public record. A living trust, on the other hand, is a private document. Because the living trust document is never filed with a court or other government entity, what you leave, and to whom, generally remains private. There are just a couple of exceptions. First, records of real estate transfers are always public, so if your successor trustee transfers real estate to a beneficiary after your death, there will be a public record of it. Second, some states require the successor trustee to disclose information about your living trust to trust beneficiaries. These requirements are explained in chapter 14.

A handful of states require that you register your living trust with the local court, but there are no legal consequences or penalties if you don't. (Registration is explained in chapter 12.) Also, registration of a living trust normally requires that you just file a paper stating the existence of the trust and the main players -- you don't file the document itself, so the terms aren't part of the public record.

In most cases, the only way the terms of a living trust might become public is if -- and this is very unlikely -- after your death someone files a lawsuit to challenge the trust or collect a court judgment you owe them.

You Can Change Your Mind at Any Time

You have complete control over your revocable living trust and all the property you transfer to it. You can:

• sell, mortgage, or give away property in the trust
• put ownership of trust property back in your own name
• add property to the trust
• change the beneficiaries
• name a different successor trustee (the person who distributes trust property after your death), or
• revoke the trust completely.

If you and your spouse create the trust together, both spouses must consent to changes, although either of you can revoke the trust entirely. (See chapter 13.)

No Trust Record Keeping Is Required While You Are Alive

Even after you create a valid trust that will avoid probate after your death, you do not have to maintain separate trust records. This means you do not have to keep a separate trust bank account, maintain trust financial records, or spend any time on trust paperwork.

As long as you remain the trustee of your trust, the IRS does not require that a separate trust income tax return be filed. (IRS Reg. § 1.671-4.) You do not have to obtain a trust taxpayer ID number. You report all trust transactions on your regular income tax returns. In sum, for tax purposes, living trusts don't exist while you live.

You Can Name Someone to Manage Trust Property for Young Beneficiaries

If there's a possibility that any of your beneficiaries will inherit trust property while still young (not yet 35), you may want to arrange to have someone manage that property for them until they're older. If they might inherit before they're legally adults (age 18), you should definitely arrange for management. Minors are not allowed to legally control significant amounts of property, and if you haven't provided someone to do it, a court will have to appoint a property guardian.

When you create a living trust with this book, you can arrange for someone to manage property for a young beneficiary. In most states, you have two options:

• Have your successor trustee (or your spouse, if you created a shared living trust) manage the property in a child's trust until the child reaches an age you designate.
• In all but two states (South Carolina and Vermont), you can appoint an adult as a "custodian" to manage the property until the child reaches an age specified by your state's Uniform transfers to Minors act (18 in a few states, 21 in most, but up to 25 in a few).

Both methods are explained in chapter 9.

No Lawyer Is Necessary to Distribute Your Property

With a living trust, the person you named as your successor trustee has total control over how the property is transferred to the beneficiaries you named in the trust document. With a will, technically the person in charge of the property that passes under the terms of the will is the executor you named in the will, but the probate lawyer usually runs the show. This can include the personal show as well as the silly court show. I've heard of a lawyer calling a family in for a reading of the deceased's will immediately after the funeral service, which some family members found highly insensitive. There's much less chance of this type of crassness if only close personal relations are involved in the transfer of the property.

Possible Drawbacks of a Living Trust

A basic living trust, which serves just to avoid probate, can have some drawbacks. They aren't significant to most people, but you should be aware of them before you create a living trust. Aside from the problems discussed below, an AB living trust, which is designed to save on estate taxes as well as avoid probate, has a whole set of its own potential drawbacks, which are covered in Chapter 4.

Initial Paperwork

Setting up a living trust obviously requires some paperwork. The first step is to use this book to create a trust document, which you must sign in front of a notary public. So far, the amount of work required is no more than writing a will.

There is, however, one more essential step to make your living trust effective. You must make sure that ownership of all the property you listed in the trust document is legally transferred to the living trust. (Chapter 11 explains this process in detail.) Transferring property into your trust is simply a matter of doing the paperwork correctly. What you have to do depends on the kind of property you're putting in the trust.

• If an item of property doesn't have a title (ownership) document, then in most states, listing it in the trust document is enough to transfer it. So, for example, no additional paperwork is legally required for most books, furniture, electronics, jewelry, appliances, musical instruments, paintings, and many other kinds of property.
• If an item has a title document -- real estate, stocks, mutual funds, bonds, money market accounts, or vehicles, for example -- you must change the title document to show that the property is owned by the trustee of the trust.

For example, if you want to put your house into your living trust, you must prepare and sign a new deed, transferring ownership from you to your living trust.

After the trust is created, you must keep written records sufficient to identify what's in and out of the trust, whenever you transfer property to or from the trust. This isn't burdensome unless you're frequently transferring property in and out, which is rare.

EXAMPLE: Misha and David Feldman put their house in a living trust to avoid probate, but later decide to sell it. In the real estate contract and deed transferring ownership to the new owners, Misha and David sign their names "as trustees of the Misha and David Feldman Revocable Living trust, dated March 18, 20xx."

Transfer Taxes

In virtually all states, including California, New York, Florida, and Texas, transfers of real estate to revocable living trusts are exempt from transfer taxes usually imposed on real estate transfers. Washington, DC, used to tax transfers of real estate to living trusts, but repealed those laws.

If you're the cautious type, you can check with your county tax assessor to learn if there will be any transfer tax imposed on transfer of your real estate to your trust. Your county land records office (county recorder's office or registry of deeds) may also be able to provide this information. As I've said, you're very likely to learn that no tax is imposed. If there is a tax but it is minor, it may impose no serious burden on creating your trust. If the tax is substantial, you may decide it's too costly to place your real estate in a trust.

Difficulty Refinancing Trust Real Estate

Because legal title to trust real estate is held in the name of the trustee of the living trust -- not your name -- some banks, and especially title companies, may balk if you want to refinance it. They should be sufficiently reassured if you show them a copy of your trust document, which specifically gives you, as trustee, the power to borrow against trust property.

In the unlikely event you can't convince an uncooperative lender to deal with you in your capacity as trustee, you'll have to find another lender (which shouldn't be hard) or simply transfer the property out of the trust and back into your name. Later, after you refinance, you can transfer it back into the living trust. It's a silly process, but one that does work.

No Cutoff of Creditors' Claims

Most people don't have to worry that after their death creditors will try to collect large debts from property in their estate. In most situations, there are no massive debts. Those that exist, such as outstanding bills, taxes, and last illness and funeral expenses, can be readily paid from the deceased's property. But if you are concerned about the possibility of large claims, you may want to let your property go through probate instead of a living trust.

If your property goes through probate, creditors have only a set amount of time to file claims against your estate. A creditor who was properly notified of the probate court proceeding cannot file a claim after the period -- about six months, in most states -- expires.

EXAMPLE: Elaine is a real estate investor with a good-sized portfolio of property. She has many creditors and is involved in a couple of lawsuits. It's sensible for her to have her estate transferred by a probate court procedure, which allows creditors to present claims, resolves conflicts, and cuts off the claims of creditors who are notified of the probate proceeding but don't present timely claims.

On the other hand, when property isn't probated, creditors still have the right to be paid (if the debt is valid) from that property. In most states, there is no formal claim procedure. (California has enacted a statutory scheme for creditors to get at property transferred by living trust.) The creditor may not know who inherited the deceased debtor's property, and once the property is found, the creditor may have to file a lawsuit, which may not be worth the time and expense.

If you want to take advantage of probate's creditor cutoff, you must let all your property pass through probate. If not, there's a good chance the creditor could still sue (even after the probate claim cutoff) and try to collect from the property that didn't go through probate and passed instead through your living trust.

Introduction

Living trusts are an efficient and effective way to transfer property, at your death, to the relatives, friends, or charities you've chosen. Essentially, a living trust performs the same function as a will, with the important difference that property left by a will must go through the probate court process. In probate, a deceased person's will is proved valid in court, the person's debts are paid, and, usually after about a year, the remaining property is finally distributed to the beneficiaries. In the vast majority of instances, these probate court proceedings are an utter waste of time and money.

By contrast, property left by a living trust can go promptly and directly to your inheritors. They don't have to bother with a probate court proceeding. That means they won't have to spend any of your hard-earned money (at least, I presume it was hard-earned) to pay for court and lawyer fees.

You don't need to maintain separate tax records for your living trust. While you live, all transactions that are technically made by your living trust are simply reported on your personal income tax return. Indeed, while some paperwork is necessary to establish a probate-avoidance living trust and transfer property to it, there are no serious drawbacks or risks involved in creating or maintaining the trust.

These trusts are called "living" or sometimes "inter vivos" (Latin for "among the living") because they're created while you're alive. They're called "revocable" because you can revoke or change them at any time, for any reason, before you die.

While you live, you effectively keep ownership of all property that you've technically transferred to your living trust. You can do whatever you want to with any trust property, including selling it, spending it, or giving it away. A revocable living trust becomes operational at your death. At that point, it allows your trust property to be transferred, privately and outside of probate, to the people or organizations you have named as beneficiaries of the trust.