A House Divided: the Purchase by the Surviving Spouse of an Interest in the Family Residence Following Its Allocation to a Credit Trust

• Citation: Vol. 14 No. 3
• Publication year: 2008
• Author: By James P. Lamping, Esq.

A HOUSE DIVIDED: THE PURCHASE BY THE SURVIVING SPOUSE OF AN INTEREST IN THE FAMILY RESIDENCE FOLLOWING ITS ALLOCATION TO A CREDIT TRUST

By James P. Lamping, Esq.^*

I. INTRODUCTION

Following the death of the first spouse, the allocation of the family residence in a two trust division can present unique challenges for the trustee.¹ Commonly, the value of the residence exceeds one half of the value of the community trust estate to be divided. However, it is generally disadvantageous to the surviving spouse for even a fractional share of the residence to be held by a credit trust.

One solution to this dilemma is for the surviving spouse to buy back the share that has been allocated to the credit trust. While this technique can be effective and is frequently used in practice, certain issues should be considered before completing this transaction. In particular, the trustee of the credit trust may be confronted with tensions between their fiduciary duties to the remainder beneficiaries and the desire to permit the surviving spouse to purchase the residence. There is also some concern regarding the income tax consequences of this transaction. This article will examine this common scenario, and analyze the practical considerations the trustee may wish to take into account before taking action.

II. THE DILEMMA

The family residence often is the largest single asset to be divided following the death of the first spouse in a two or three trust division, particularly in modest estates. A common result is that a portion of the family residence must be funded into the credit trust.

For example, suppose that a joint trust holds two items of community property: a residence worth $1 million and a brokerage account with a value of $500,000.² One half of the $1.5 million total value of these assets, or $750,000, must be allocated to the credit trust.³ Even if the entire $500,000 brokerage account is allocated to the credit trust using a non-pro rata allocation, the trustee still must allocate $250,000 from the residence to the credit trust.⁴

A surviving spouse may react negatively to an allocation of any interest in his or her residence to the credit trust for several reasons. The first reaction may be purely visceral: a person's home is usually very personal to them, and often symbolizes stability and security, particularly after the death of a spouse. Now confronted with the thought of even a portion of their residence being allocated to a credit trust, the surviving spouse may ask "what do you mean I won't own my home any more?"

This transaction may also be disadvantageous from a purely rational business perspective. Credit trusts were traditionally used to minimize estate tax at the second spouse's death. While this often results in negative income tax results, the estate tax rate was high enough that a family could achieve overall tax savings. However, with the increase in the applicable exclusion amount, estate taxes are no longer a concern for many middle class clients. This leaves only the potentially negative income tax results, with no corresponding estate tax benefit. Nevertheless, credit trusts often continue to play a vital role in estate planning for middle class clients. For example, a credit trust may be used to provide for the surviving spouse while ensuring that assets will pass to the deceased spouse's children, or to protect the surviving spouse from elder abuse or undue influence.⁵

Unlike estate tax consequences, which may arise upon the death of the surviving spouse, the income tax impact of the family residence being held by the credit trust may occur during the surviving spouse's lifetime. For example, Internal Revenue Code (hereafter, "IRC") section 121 generally permits a taxpayer to exclude from income $250,000 of gain on the sale of a residence "owned and used by the taxpayer as the taxpayer's principal residence" for two of the last five years. However, that portion of the residence allocated to the credit trust is not "owned by the tax-payer."⁶ As a result, it may be necessary for capital gains taxes to be paid upon the future sale of the residence, where they could have been avoided if the residence had been owned outright by the surviving spouse.

The surviving spouse may also lose the home mortgage interest deduction with respect to the portion of the residence held by the credit trust. Theoretically, the home mortgage interest deduction may be taken by the credit trust if the surviving spouse uses the property as a residence.⁷ The practical problem is that the credit trust may have little or no income if its primary asset is the surviving spouse's home, meaning that the deduction may be lost entirely, as the trust will have no income to offset.⁸

Assuming that the surviving spouse will not disinherit the remainder beneficiaries, the retention of the residence by the credit trust may be even less attractive. Where it is anticipated that there not will be an estate tax payable at the death of the second spouse, the remainder beneficiaries will not receive a stepped-up basis as to that portion of the residence allocated to the credit trust.⁹ Because no estate taxes would have been imposed in any event, no estate tax savings have been achieved. Even where it is anticipated that there may be an estate tax upon the death of the surviving spouse, the allocation of the residence to the credit trust may preclude certain estate planning techniques by the surviving spouse.¹⁰ For these reasons, the surviving spouse often desires to own the residence outright.

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III. A POSSIBLE SOLUTIO3N

Many of the difficulties associated with the credit trust owning an interest in the surviving spouse's residence may be avoided by having the surviving spouse purchase the share allocated to the credit trust.

For example, suppose that a two settlor trust consists entirely of a community property residence with a value of $2 million, and that one half of the residence is allocated to the credit trust immediately after the death of the first spouse.¹¹ The surviving spouse immediately buys the half interest allocated to the credit trust for $1 million, using a note secured by a deed of trust. Following this transaction, the surviving spouse owns the $2 million residence subject to a debt of $1 million (in other words, $1 million in equity), and the credit trust owns the $1 million note secured by the residence.

This example sounds simple, but there may be a number of practical complicating factors. In particular, careful consideration should be given to the trustee's fiduciary duties, particularly if the surviving spouse is acting as trustee of the credit trust. Moreover, the holding of the secured note may create income tax consequences for the surviving spouse and the credit trust. In practice, many practitioners just disregard the theoretical income tax accounting implications of this transaction; however, there is some risk in choosing this path.

IV. FIDUCIARY DUTIES

As described above, a purchase of the residence from the credit trust may be very attractive from the surviving spouse's perspective. The remainder beneficiaries, however, may be less enthusiastic. Once the transaction is completed, the surviving spouse will own the residence outright. This means that all future appreciation associated with the residence will inure solely to the surviving spouse. Meanwhile, the credit trust will hold a note that will not increase in value.

For example, suppose that a community property residence with a total value of $2 million is the sole asset in a two trust division. One half of the residence is allocated to the survivor's trust, and the other half is allocated to the credit trust. The surviving spouse purchases one half of the residence from the credit trust in exchange for a $1 million note. The surviving spouse now owns the entire residence, subject to the debt. The surviving spouse remarries several years later, and amends the survivor's trust to leave everything to the new spouse, rather than the children of the deceased spouse.¹² Upon the death of the surviving spouse many years later, the value of the residence has increased to $3,000,000. The surviving spouse's new spouse receives the $3,000,000 residence less the $1 million owed to the credit trust, or $2,000,000. In contrast, the stepchildren receive $1,000,000 that was repaid from the surviving spouse's estate to the credit trust. The stepchildren may not embrace this result.

The duties imposed upon trustees by the Probate Code may provide a number of bases for attacking this transaction. In particular, the stepchildren may complain that the stepparent-trustee has breached the duty of loyalty,¹³ the duty to deal impartially with beneficiaries,¹⁴ the duty to avoid conflict of interest,¹⁵ the duty to make trust property productive,¹⁶ and perhaps other duties as well.¹⁷ Even where the boilerplate language of a trust provides that a trustee has broad discretion, the Probate Code imposes a duty to exercise discretionary powers reasonably.¹⁸ Moreover, a general statement in a trust that the trustee is not bound by the Uniform Prudent Investor Act will not necessarily save the trustee from liability under the Act, even where the trust holds publicly traded stock.¹⁹ Holding a single note, even one secured by real property, could be even riskier.

That is not to say that a trust could not provide the trustee with the ability to complete this transaction. A settlor may authorize a trustee to favor one class of beneficiaries over another, and indeed may make a challenge of the trustee's decision to do so a violation of the trust's no contest clause.²⁰ Providing the spouse with the option to engage in this transaction does not inherently violate public policy. However, careful drafting is necessary at the planning stage.

A separate section below proposes draft language that may be adopted to permit the surviving spouse to engage in this transaction, but one issue in particular should be...