Estate Planning

Changing Uses for Bypass Trusts

Every year, each individual who dies in the U.S. can leave a certain amount of money to his or her heirs before facing any federal estate taxes. For example, in 2010, a person who died could leave $3.5 million to his or her heirs (or a charity) estate tax free, and everything over that amount would be taxable by the federal government. Transfers at death to a spouse are not taxable.

Therefore, if a husband died owning $5 million in assets in 2010 and passed everything to his wife, that transfer was not taxable because transfers to spouses at death are not taxable. However, if the wife died later that year owning that $5 million in assets, everything over $3.5 million (her exemption amount) would be taxable by the federal government. Couples would effectively only have the use of one exemption amount unless they did some special planning, or left a chunk of their property to someone other than their spouse.

Estate tax law provided a tool called “bypass trusts” that would allow a spouse to leave an inheritance to the surviving spouse in a special trust. That trust would be taxable and would use up the exemption amount of the first spouse to die. However, the remaining spouse would be able to use the property in that bypass trust to live on, and would also have the use of his or her exemption amount when he or she passed. This planning technique effectively allowed couples to combine their exemption amounts.

Late last year, Congress changed the estate tax rules. For the years 2011 and 2012, each person who dies can pass $5 million free from federal estate taxes. In addition, spouses can combine their exemption amounts without requiring a bypass trust (making the exemptions “portable” between spouses). This change in the law appears to make bypass trusts useless, at least until Congress decides to remove the portability provision from the estate tax law.

However, bypass trusts can still be valuable in many situations, such as:

(1)  Remarriage or blended families. You may be concerned that your spouse will remarry and cut the children out of the will after you are gone. Or, you may have a blended family and you may fear that your spouse will disinherit your children in favor of his or her children after you pass. A bypass trust would allow the surviving spouse to have access to the money to live on during life, while providing that everything goes to the children at the surviving spouse’s death.

(2)  State estate taxes. Currently, 13 states as well as Washington D.C. have state estate taxes. If you live in one of those states, a bypass trust may be necessary to combine a couple’s exemptions from state estate tax.

(3)  Changes in the estate tax law. Estate tax laws have been in flux over the past several years. What if you did an estate plan assuming that bypass trusts were unnecessary, Congress removed the portability provision, and you neglected to update your estate plan? You could be paying thousands or even millions of dollars in taxes that you could have saved by using a bypass trust.

(4)  Protecting assets from creditors. If you leave a large inheritance outright to your spouse and children, and a creditor appears on the scene, the creditor may be able to seize all the money. Although many people think that will not happen to their family, divorces, bankruptcies, personal injury lawsuits, and hard economic times can unexpectedly result in a large monetary judgment against a family member.

Although it may appear that bypass trusts have lost their usefulness, there are still many situations in which they can be invaluable tools to help families avoid estate taxes.

Should I Transfer My Home to My Children?

Most people are aware that probate should be avoided if at all possible. It is an expensive, time-consuming process that exposes your family’s private matters to public scrutiny via the judicial system. It sounds simple enough to just gift your property to your children while you are still alive, so it is not subject to probate upon your death, or to preserve the asset in the event of significant end-of-life medical expenses.

This strategy may offer some potential benefits, but those benefits are far outweighed by the risks. And with other probate-avoidance tools available, such as living trusts, it makes sense to view the risks and benefits of transferring title to your property through a very critical lens.

Potential Advantages:

• Property titled in the names of your heirs, or with your heirs as joint tenants, is not subject to probate upon your death.
• If you do not need nursing home care for the first 60 months after the transfer, but later do need such care, the property in question will not be considered for Medicaid eligibility purposes.
• If you are named on the property’s title at the time of your death, creditors cannot make a claim against the property to satisfy the debt.
• Your heirs may agree to pay a portion, or all, of the property’s expenses, including taxes, insurance and maintenance.

Potential Disadvantages:

• It may jeopardize your ability to obtain nursing home care. If you need such care within 60 months of transferring the property, you can be penalized for the gift and may not be eligible for Medicaid for a period of months or years, or will have to find another source to cover the expenses.
• You lose sole control over your property. Once you are no longer the legal owner, you must get approval from your children in order to sell or refinance the property.
• If your child files for bankruptcy, or gets divorced, your child’s creditors or former spouse can obtain a legal ownership interest in the property.
• If you outlive your child, the property may be transferred to your child’s heirs.
• Potential negative tax consequences: If property is transferred to your child and is later sold, capital gains tax may be due, as your child will not be able to take advantage of the IRS’s primary residence exclusion. You may also lose property tax exemptions. Finally, when the child ultimately sells the property, he or she may pay a higher capital gains tax than if the property was inherited, since inherited property enjoys a stepped-up tax basis as of the date of death.

There is no one-size-fits-all approach to estate planning. Transferring ownership of your property to your children while you are still alive may be appropriate for your situation. However, for most this strategy is not recommended due to the significant risks. If your goal is to avoid probate, maximize tax benefits and provide for the seamless transfer of your property upon your death, a living trust is likely a far better option.