For this four-part series, we are discussing very common scenarios that we see in our trust administrations where real estate is involved. Real estate, particularly the family home, often has emotional and sentimental components that throw a wrench in trust administrations. Beneficiaries often have different ideas of what to do with the family home.
We will continue using the same scenario, which is very common in trust administrations.
Harry and Wendy, a married couple living in California, created a revocable trust during their lives as a part of their estate plan. They have three adult children: Susie, Tom, and Michael. When Harry and Wendy die, their trust becomes irrevocable and it holds the house that the children were raised in, a checking account with $40,000, and a brokerage account with $300,000. They purchased the house for $100,000 and its fair market value is $900,000 as-is and could fetch up to $1,500,000 if they put $300,000 worth of deferred maintenance and upgrades into the property. The house is assessed by the county assessor at $300,000 for property tax purposes.
Harry and Wendy’s trust names Susie as their successor trustee and all assets are to be divided equally between the three children. The trust allows for in-kind distributions, meaning the kids can pick and choose what assets they receive as long as they each receive assets adding up to their 1/3 shares. They don’t have to split each asset in three ways.
In Part II of this series, we are going to discuss what happens when one beneficiary wants to keep the house.
Michael wants to buy his siblings out and also maintain low property taxes under Prop 19 by living there.
Here, one sibling wants to take the house as a part of his 1/3 share and add cash to the trust to cover the difference between the amount he is entitled to and the value of the whole house, which is what he wants. This is doable but can raise some issues.
As we discussed in Part One, the property is going to be reassessed for property taxes under Prop 19 (see more about property taxes and Prop 19 here: https://absolutetrustcounsel.com/all-about-taxes-with-an-estate-planning-flair-part-iii/). This means that the property taxes will increase from $3,000 per year to $9,000 – $15,000 per year. However, the exemption from reassessment may apply because the house was Harry and Wendy’s primary residence and would become Michael’s primary residence under this scenario. The concern here is that if Michael’s 1/3 share does not cover the full fair market value of the house, then there will be at least a partial reassessment. Let’s do the math.
The amount to be divided between the three children is $1,240,000 ($40,000 checking account, $300,000 brokerage account, and $900,000 house). This means each child’s share is about $413,333. If Michael uses his $413,333 towards the house and pays his siblings the difference of $486,667 (the value of the house minus Michael’s share), then the county assessor would deem that to be a sibling-to-sibling transfer of 54% of the house, which is not a type of transfer that is exempt from reassessment. This means that the assessor would reassess the 54% for property tax purposes and Michael would be able to keep his 46% of the property taxes low, and then have to pay the increased, reassessed taxes for the other 54%.
There is a way to avoid this. A special type of loan approved through the State Board of Equalization can be used to avoid the “sibling-to-sibling” transfer that will trigger a reassessment. These bridge loans, as they are called, are short-term loans to irrevocable trusts. This means that Susie, as trustee, could borrow the $486,667 within the trust, and the loan would be secured by the house. This adds cash to the trust, allowing each sibling to take their 1/3 share in cash and securities, and Michael can receive the house, subject to this $486,667 loan, as his 1/3. This is acceptable and will avoid any reassessment, meaning Michael gets the house with the loan and can keep the property taxes assessed at the low $300,000 value.
Bridge loans are a great tool to keep those taxes low and allow beneficiaries to buy each other out without reassessment; however, there are some caveats. Bridge loans are not designed as a mortgage. They are short-term, with higher fees and interest rates, both of which need to be paid by the beneficiary benefitting from this type of arrangement. Typically, beneficiaries who take a residence subject to the bridge loan will need to refinance the loan into a traditional mortgage pretty quickly. While this is advantageous, traditional mortgages are less expensive, it’s important to consider whether or not the beneficiary will be able to do so.
Can Michael afford a mortgage? Can he qualify for a mortgage personally? Is the loan-to-value ratio of the house too high to obtain a mortgage? These are all questions to consider. Before a bridge loan is obtained, the beneficiary needs to work with a mortgage broker to see if they can pre-qualify for the mortgage first. Working with lenders who have handled these types of transactions is important to ensure everything is done correctly and everyone qualifies properly. Additionally, working with an attorney to prepare the deeds and the proper paperwork for the county is important so that reassessment does not occur.
Come back next month for Part III as we discuss the next common situation of when a child is living with and caring for the parents at the end of their lives and the promises or expectations to that child that invariably ensue.
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