Living Trusts for the Homestead

Introduction

The living trust is a tried and true means of providing for one’s heirs and avoiding probate of title to the home. A trust of this type should be distinguished from other kinds of land trusts—for example, an anonymity trust that has no probate objectives, or an investment trust that contemplates a transfer of underlying ownership by means of an assignment of beneficial interest (described in a different article on investor land trusts). There is another category—testamentary trusts—which take effect upon death of the trustor. These are not discussed in this article.

A Living Trust as Part of an Estate Plan

A living trust that includes the homestead should be considered, along with a pour-over will, as part of most middle class estate plans. Note that the emphasis here is on probate avoidance and not asset protection. Why? Because homesteads are already protected in Texas from forced sale to satisfy judgments. Tex. Const. Art. XVI, Sec. 50; Tex. Prop. Code Chaps. 41 and 42. So it is useful to generally distinguish between homestead-exempt assets (protected) and cash or investment assets (generally unprotected).

Should living trusts be used for the long-term holding of rental properties and other investments? We see this frequently promoted in investment and asset protection seminars. The problem is that trusts have no liability barrier as do LLCs, corporations, and limited partnerships, and a liability barrier should be a priority for real estate investors. An LLC is usually the preferred vehicle for real estate investing, not a trust.

Trust Basics

While trusts can be used flexibly with many variations, there are certain basic legal principles that do not change:

(1) The trustor (sometimes called the settlor or grantor) is the person or entity who
transfers property into the trust.

(2) The trust corpus (or trust estate) is the asset—in this case investment property—that is conveyed into the trust.

(3) The trustee controls the trust with authority to manage, maintain, lease, and sell the trust property. An LLC cannot usually be designated as trustee.

(4) The successor trustee serves if the trustee dies, resigns, or cannot otherwise serve.

(5) The beneficiary is the ultimate party in interest for whom the trust is being operated—the one with “ownership” to use that term loosely. An LLC can be a beneficiary.

(6) The contingent beneficiary or successor beneficiary acquires the beneficial interest if the primary beneficiary dies.

In order for an attorney to draft a trust, the client needs to specify which persons or entities will be acting in each role. Note that “a trust terminates if the legal title to the trust property and all equitable interests in the trust become united in one person,” known as the doctrine of merger found both in common law and in Property Code Section 112.034. So the person or persons acting in each of the three main roles cannot exactly match. As a practical matter, particularly when dealing with lenders and title companies, it is better if these actors overlap as little as possible. This enhances the perceived legitimacy of the trust.

Once the principals are identified, the next steps are to: (1) formally establish the trust by means of a signed and dated trust agreement, and then (2) convey the real property into trust by means of a warranty deed (usually a general warranty deed).

Duties of a Trustee

An examination of trusts of any type would be incomplete without mentioning the legal duties of a trustee. When serving as trustee for others, a trustee is a fiduciary and has certain duties with respect to both the beneficiaries and the property held in the trust, and these are significant, as is the potential liability for failing to perform these duties. Fiduciary standards may not be very important if the trustee is also the sole beneficiary of the trust (not a recommended set-up), but otherwise such considerations are very relevant indeed.

The duties of a trustee include:

(1) a duty of loyalty;
(2) a duty of competence;
(3) a duty to exercise reasonable discretion;
(4) a duty of disclosure with respect to the beneficiaries; and
(5) a duty to comply with the prudent investor rule contained in Prop. Code Section 117.003.

While a trust agreement can attempt to reduce or mitigate some of these duties, it cannot eliminate them entirely, at least not as to intentional, bad faith, or reckless actions by the trustee (Prop. Code Sec.114.007).

Trust Protector

There is another possible player in the structure of a trust: the trust protector, a new role recognized by the Texas Trust Code in 2015. According to Property Code Section 114.0031(d), the trust protector (also referred to as an advisor in the statute), “has all the power and authority granted to the protector by the trust terms, which may include: (1) the power to remove and appoint trustees, advisors, trust committee members, and other protectors; (2) the power to modify or amend the trust terms to achieve favorable tax status or to facilitate the efficient administration of the trust;  and (3) the power to modify, expand, or restrict the terms of a power of appointment granted to a beneficiary by the trust terms.” A trust involving a trust protector may be referred to as a “directed trust.”

The rationale for having a trust protector or advisor is that the appointed trustee (also referred to as the “directed trustee”) may not have the expertise to manage certain specialized investments such as real estate or oil and gas . . . which begs the question: if the trustee is not qualified, and needs to be directed by some other individual, then why is he appointed in the first place?

Another issue: the statute provides that the trust protector may or may not be a fiduciary – which raises an additional question: if a person with such critical powers is not going to be one’s protector in a fiduciary capacity, then what is he doing in the mix in the first place?

Consider the case of a trust protector gone rogue in Suzanne Ron v. Avishai Ron, et al, No. 20-40248 (5th Cir. 2020). In this case, the trust protector not only added another beneficiary to the trust but also (allegedly) fraudulently transferred $1.3 million to legal counsel – all against the wishes of the trustor. Notwithstanding that (1) the statute states that an advisor [protector] “is a fiduciary regardless of trust terms to the contrary….”; and (2) the trust agreement expressly stated that the trust protector’s authority was “conferred in a fiduciary capacity,” the court bizarrely concluded the no fiduciary relationship existed, either formal or informal, and dismissed the case.

If nothing else about the trust protector statute stands out to you as problematic, then the result in Ron should be more than sufficient reason to avoid trust protectors.

Law Applicable to Trusts and Trustees

The law applicable to trusts and trustees is found in a mixture of that portion of the Property Code known as the “Texas Trust Code” (Prop. Code Chaps. 112-117, contained in Title 9 of the Code); the Restatement of Trusts (second and third versions), a body of academic literature that states common-law principles applicable to trusts; and case law as it is reported from the Texas courts. All of these sources make it fearfully easy for a beneficiary to sue and win against a trustee for breach of duty, especially in cases of trustee self-dealing, which is a breach of the duty of loyalty.

Section 113.053 of the Property (Trust) Code provides that except in limited circumstances “a trustee shall not directly or indirectly buy or sell trust property from or to: (1) the trustee or an affiliate; (2) a director, officer, or employee of the trustee or an affiliate; (3) a relative of the trustee; or (4) the trustee’s employer, partner, or other business associate.” An old supreme court case puts this succinctly: “[A] trustee, or person occupying a fiduciary relation to another, is incapacitated, in equity, to buy from himself property committed to his care, or secure to himself an advantage in a purchase of such property by another from him.” Tenison v. Patton, 67 S.W. 92, 93-94 (Tex. 1902). Note that in cases where this duty is breached, it falls to the beneficiary (and really no one else) to raise the issue. Harvey v. Casebeer, 531 S.W.2d 206, 208 (Tex.App.—Tyler 1975, no writ).

The law makes it clear that a trustee has an active duty to take reasonable measures to protect trust property and make it productive. The exact extent of this duty can be argued in any particular case; however, at the very minimum, a trustee is obliged to ensure that property belonging to the trust is not subject to unnecessary waste, loss, or other diminishment. Central to this is the “prudent investor rule” found in the Restatement (Third) of Trusts which sets forth core principles: (1) a preference for lower risk to achieve a beneficial rate of return; (2) applied as an overall strategy (which does not mean that any single investment needs to comply with this concept); plus (3) reasonable diversification to manage risk and avoid unnecessary loss; along with (4) a view toward increasing returns over time if that is reasonably feasible; (5) and, having said the foregoing, a trustee should nonetheless retain flexibility to actively take advantage of unique or special opportunities as they may arise.

A “Uniform Prudent Investor Act” is included within the Texas Trust Code (Chapter 117 of the Property Code). This law takes the general principles of the Restatement of Trusts and gets more specific, stating that “a trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.” Prop. Code Sec.117.004(a). The same section goes on to list specific items that a trustee should consider: “(1) general economic conditions; (2) the possible effect of inflation or deflation; (3) the expected tax consequences of investment decisions or strategies; (4) the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property; (5) the expected total return from income and the appreciation of capital; (6) other resources of the beneficiaries; (7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and (8) an asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.”

Investors and Lawyers as Trustees

Note that if a real estate investor has considerable experience and knowledge of the business, then he or she will be held to a higher standard when acting as trustee for another: “A trustee who has special skills or expertise, or is named as trustee in reliance upon the trustee’s representation that the trustee has special skills or experience, has a duty to use those special skills or expertise.” Prop. Code Sec. 117.004(f). All of this should highlight the liability risk involved in anyone acting as trustee.

Lawyers are often asked to act as trustees for their clients’ trusts. Considering the extensive duties and liabilities, it is not surprising that lawyers are reluctant to do so without substantial compensation, especially since trustees are sued all the time. In fact, when the trust is sued, it is the trustee who is named as the defendant.

Creating a Living Trust for the Homestead

Three steps are involved: (1) establishing the trust with a signed trust agreement; (2) executing and filing a warranty deed conveying the home into the trust; and (3) executing a pour-over will to move miscellaneous assets into the trust upon death.

As with other trusts, a trustor establishes the trust and conveys property into it. A trustee (or co-trustees if husband and wife) directs trust affairs on behalf of the beneficiaries (often the children). Since title remains in the trust, and the trust does not die, the surviving beneficiaries automatically “inherit” the trust property but without probate or other involvement by courts or lawyers.

The trust agreement should state the trust’s purpose in general terms along the following lines: “to hold, preserve, maintain, and distribute the Trust Property for the benefit of the Beneficiaries, including but not limited to payment of expenses for their respective health, education, maintenance, and support as the Trustee, acting in his or her sole discretion, deems reasonable, prudent, and necessary.” Texas law confers wide powers upon a trustee including selling and purchasing trust property but imposes a fiduciary duty in the management of the trust and its assets.

The trustor usually reserves the right to revoke or amend the usual living trust for the homestead. The terms of the trust are therefore not finally fixed until the trustor dies (or, in the case of husband and wife co-trustees, when the surviving spouse dies) at which time most living trusts become irrevocable. No deed or probate is required. Even though Texas has an expedited probate process, the result may be a considerable saving of time, effort, and attorney’s fees.

The trust agreement, unlike the warranty deed that follows it, should not be recorded. It is a private and confidential document, the terms of which need not even be disclosed to the beneficiaries.

A spendthrift clause is usually included that prohibits a beneficiary from assigning his or her interest in the trust to creditors.

Trust Property

In this article, we are discussing living trusts for the homestead. However, trust property may be of any type, whether personal or real, tangible or intangible, and wherever located. Additional property may be transferred into trust at a later date after the trust is established.

Real property is conveyed into trust by general or special warranty deed recorded in the county clerk’s real property records. The deed should make certain specific recitals concerning the homestead nature of the property. Conveying the property by deed into the living trust is an essential part of the process since the trust agreement, by itself, does not transfer title.

The trust need not formally assume existing liabilities on trust property in order for the transfer to be effective. Property can be taken “subject to” existing indebtedness (i.e., without the trust or trustee taking any liability for the debt), or the debt can be assumed or wrapped. “Subject to” is more common in the trust context.

Transferring the homestead into a revocable living trust does not reduce a trustor’s assets for Medicaid purposes. Trust property is still counted by Medicaid as belonging to the trustor.

Duration of Trusts

Historically and at common law, the duration of a trust was governed by the Rule Against Perpetuities which states that a trust interest must vest, if at all, “within a life or lives in being at the time of the testator’s death and twenty-one years thereafter, and when necessary, the period of gestation.” Foshee v. Republic Nat’l Bank of Dallas, 617 S.W.2d 675 (Tex. 1981). This has changed in an attempt to make the trust business in Texas more competitive with other states that are aggressively pushing the boundaries of traditional trust law (South Dakota, for example).

For trusts executed after September 1, 2021, an “interest in a trust must vest, if at all: (1) not later than 300 years after the effective date of the trust, if the effective date of the trust is on or after September 1, 2021; or (2) except as provided by Subsection (d), not later than 21 years after some life in being at the time of the creation of the interest, plus a period of gestation, if the effective date of the trust is before September 1, 2021.” Tex. Prop. Code Sec. 112.036(c). However, Section 112.036(f) provides that real property may not be tied up in a trust for more than 100 years.

Preserving the Homestead Tax Exemption with a “Qualifying Trust”

Living trusts for the homestead should contain language that (1) claims homestead protections against execution on a judgment pursuant to Texas Constitution Article XVI, Section 50 and Property Code Chapters 41 and 42; and (2) preserves any available homestead tax exemption whether currently on file or not. It is prudent to make express recitals to this effect in the trust agreement even though Property Code Section 41.0021 states that transfer of a homestead into a “qualifying trust” retains the homestead character of the property. Similar language should also be recited in the deed into the trust so as to make it clear to the local taxing authorities that a qualifying living trust has been established for the homestead.

Note that we are talking about two different aspects of “homestead” here—the exemption from judgment execution generally and also the specific tax exemption granted by the local appraisal district. These are related, but conceptually distinct, and are often conflated.

The law applicable to qualifying trusts is found in Property Code Section 41.0021:

Property Code Sec. 41.0021. Homestead in Qualifying Trust

(a) In this section “qualifying trust” means an express trust:

(1) in which the instrument or court order creating the express trust provides that a settlor or beneficiary of the trust has the right to: (A) revoke the trust without the consent of another person; (B) exercise an inter vivos general power of appointment over the property that qualifies for the homestead exemption; or (C) use and occupy the residential property as the settlor’s or beneficiary’s principal residence at no cost to the settlor or beneficiary, other than payment of taxes and other costs and expenses specified in the instrument or court order: (i) for the life of the settlor or beneficiary; (ii) for the shorter of the life of the settlor or beneficiary or a term of years specified in the instrument or court order; or (iii) until the date the trust is revoked or terminated by an instrument or court order recorded in the real property records of the county in which the property is located and that describes the property with sufficient certainty to identify the property; and

(2) the trustee of which acquires the property in an instrument of title or under a court order that: (A) describes the property with sufficient certainty to identify the property and the interest acquired; and (B) is recorded in the real property records of the county in which the property is located.

(b) Property that a settlor or beneficiary occupies and uses in a manner described by this subchapter and in which the settlor or beneficiary owns a beneficial interest through a qualifying trust is considered the homestead of the settlor or beneficiary under Section 50, Article XVI, Texas Constitution, and Section 41.001.

(c) A married person who transfers property to the trustee of a qualifying trust must comply with the requirements relating to the joinder of the person’s spouse as provided by Chapter 5, Family Code.

(d) A trustee may sell, convey, or encumber property transferred as described by Subsection (c) without the joinder of either spouse unless expressly prohibited by the instrument or court order creating the trust.

(e) This section does not affect the rights of a surviving spouse or surviving children under Section 52, Article XVI, Texas Constitution, or Chapter 353, Estates Code.

A common misconception is that a “qualifying trust” must be a revocable living (or inter vivos) trust; however, the statute inserts an “or” to provide, by implication, that an irrevocable trust qualifies so long as the trustor or the beneficiary of the trust retains the use and occupancy of the home as the trustor’s or the beneficiary’s principal residence at no cost to the trustor or beneficiary. Accordingly, it is common for appraisal districts to require that the trust agreement (or the deed conveying the property into trust) contain a provision that the trustor may continue living in the property without paying rent or costs.

The statute makes clear that in order to constitute a qualifying trust, the person residing there must be either a trustor or a beneficiary. A trustee who is not also a trustor or a beneficiary cannot claim a qualifying trust.

FNMA Requirements for Trusts Eligible to be a Borrower

If a living trust is going to borrow or refinance utilizing a FNMA loan, there are requirements similar to those for a qualifying trust under Texas law. Specifically, if the trust is to be the borrower, then the “inter vivos revocable trust must be established by one or more natural persons, solely or jointly. The primary beneficiary of the trust must be the individual(s) establishing the trust. If the trust is established jointly, there may be more than one primary beneficiary as long as the income or assets of at least one of the individuals establishing the trust will be used to qualify for the mortgage. The trustee(s) must include either: the individual establishing the trust (or at least one of the individuals, if there are two or more); or an institutional trustee that customarily performs trust functions in and is authorized to act as trustee under the laws of the applicable state. The trustee(s) must have the power to mortgage the security property for the purpose of securing a loan to the individual (or individuals) who are the borrower(s) under the mortgage or deed of trust note.” (See FNMA Selling Guide B2-2-05 which can be found online).

Hybrid Trusts: Homestead + Investments

What about other assets other than the homestead, either personal or business? Can the homestead trust contain these as well? The answer is tentative yes, but individual circumstances need to be examined carefully to make sure this is a suitable approach. One asset that can be included is the trustor’s interest in a holding company (that portion of our recommended two-company structure that is dedicated to owning hard assets). An LLC membership interest is personal property, and like any other personal property can be bequeathed by means of a last will and testament; but placing it in a living trust avoids any necessity for probate. The downside, at least from a general asset protection perspective, is that one is “mixing” the homestead with a business asset that could have potential liability associated with it. Again, care is needed on a case-by-case basis in order to determine if a hybrid approach is workable and acceptable in any given case.

Note that is would never be a good idea to include an investor’s dedicated management company under the same trust umbrella as the homestead, since the management LLC’s express purpose is to deal with the public and third parties—and thus be an intentional target for liability and litigation. Mixing this with the homestead in the same vehicle would be inadvisable.

As a general principle, one should not ask any particular entity to do more work than it prudently can or should be doing. In the case of trust planning, if there are multiple assets and interests that need to be considered and planned for, then one can always create a second trust, separate from the trust that holds the homestead—and that would be the safer course.

Mixing Anonymity Techniques with Living Trusts for the Homestead

There is a potential problem in seeking anonymity when deeding the homestead into a living trust. By “anonymity” we refer to the practice of deeding the trust property into the name of a generic trust – e.g., the 123 Oak Street Trust – with no mention of the name of the trustee. Since trusts are not legal entities, this is technically not the correct way to do it; however, anonymity is nonetheless accomplished, at least until a title company challenges this practice in the lead-up to a subsequent sale of the homestead. This title company challenge can be anticipated and met by preparing two deeds: one deed is filed at the time the trust is created (not showing the name of the trustee) and another deed, which does show the name of the trustee, is held in reserve for the inevitable challenge that will occur later. The idea is that the second deed can then be recorded, curing the problem ex post, while still having maintained anonymity for the duration of ownership. A creative but workable approach.

It goes without saying that this must be done very carefully in the case of a homestead, since titling and trust issues are likely to become an issue only after the trustor or trustee is deceased and therefore unavailable to sign any curative deed that a title company may demand. So that second deed (sometime called a “deed in the drawer”) must be pre-executed, notarized, and available when it is needed. Do not even think about trying this anonymity technique without a lawyer who understands the process. Achieving anonymity, even partial anonymity, is a challenge. The American legal system is built for disclosure, not concealment, so creative efforts and often significant expense are involved.

Living Trusts and Due-on-Sale

Unlike investment land trusts, federal law creates a living trust exception to the enforcement of due-on-sale clauses on homesteads that remain owner-occupied. Garn-St. Germain Depository Institutions Act, 12 U.S.C. Sec. 1701j-3. Due-on-sale is therefore not a factor when contemplating a living trust for the homestead, so long as the trustor intends to continue living there.

Pour-Over Will

It is good practice for the trustor to execute a last will and testament that contains pour-over provisions designed to include in the trust estate any property or assets that were not previously designated. Such assets “pour over” into the trust. In this way, the trust and the will work together as part of an overall strategy. It is also possible to have life insurance paid directly to the living trust. This may be advantageous for purposes of promptly paying off liens on the homestead.

Drafting and Maintaining the Trust

The purpose of a living trust is serious business and should never be relegated to fill-in-the-blank or Internet forms, most of which are not specifically designed to comply with Texas law. Additionally, it may be necessary to make amendments to the trust agreement over the years, especially if one homestead is exchanged for another or if the names of beneficiaries change. Amendments are usually easy to do. Trust maintenance can be as important as trust formation.

DISCLAIMER

Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.

Copyright © 2022 by David J. Willis. All rights reserved. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.