Living Trusts For The Texas Homestead

Topics Covered

Establishing a Living Trust
Conveying the Homestead into Trust
Qualifying Trusts: Property Code and Tax Code
Living Trusts and Real Estate Investors

Types of Land Trusts

Living trusts for the homestead should be distinguished from other kinds of land trusts—for example, trusts that are intended to hold investment property or trusts that seek transactional anonymity for the principal.

This article focuses on revocable living trusts for the homestead that are designed mainly to avoid probate as to the home and certain personal property following death of the trustor. These comprise the great majority of family trusts formed by ordinary homeowners and modest real estate investors.

Another category of trusts—testamentary trusts—that take effect only when the trustor dies. These will not be discussed in this chapter.

A probate-avoiding revocable living trust that includes the homestead should be considered (along with a pour-over will) as part of most middle-class estate plans. Creating a qualifying trust that complies with Prop. Code Sec. 41.0021 and Tax Code Sec. 11.13 also serves to preserve the property tax benefits of the homestead. More on this below.

ESTABLISHING A LIVING TRUST

Two Steps Involved

Two steps are involved in establishing a living trust for the homestead: (1) create the trust with a signed and notarized trust agreement; and (2) execute and record a warranty deed conveying the homestead into the trust (or, more precisely, into the name of the trustee acting on behalf of the trust).

Since the trust does not die, the surviving beneficiaries automatically “inherit” the trust property upon the death of the principal (the trustor)—but without probate or other involvement by courts or lawyers. Afterwards, the beneficiaries typically have the option of terminating the trust.

The Trust Agreement

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 reserves the right to revoke or amend the 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 in order to vest beneficial interests. Even though Texas has an expedited probate process, the result may be a considerable saving of time, effort, and attorney’s fees.

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

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

CONVEYING THE HOMESTEAD INTO TRUST

The Homestead is the Core Trust Asset

In asset protection planning, it is useful to distinguish between homestead-exempt assets (protected) and cash or investment properties (generally unprotected). When implementing a living trust for the homestead, the emphasis is on probate avoidance and not asset protection. Why? Two reasons:

(1) because homesteads are already protected in Texas from forced sale to satisfy judgments (pursuant to the Texas Constitution Art. XVI, Sec. 50 and Property Code Chapters 41 and 42) and this protection is solid in Texas; and

(2) because trusts have no liability barrier as do LLCs, corporations, and limited partnerships—and a liability barrier should be a priority for real estate investors. Accordingly, an LLC is usually the preferred vehicle for real estate investing, not a living trust.

As a general rule, the homestead should never be mixed together inside the same entity that owns investment property. It is simply not prudent (regardless of available legal protections) to insert the homestead into the liability-rich environment of investment and rental real estate.

Deed of Homestead into Trust

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.

Real property is conveyed into trust by general or special warranty deed that is usually recorded in the county clerk’s real property records. A well-drafted deed of this type will make specific recitals concerning the homestead nature of the property.

The trust into trust can be (and usually is) made “subject to” the existing indebtedness (i.e., without the trust or trustee taking any liability for the debt). Alternatively, the indebtedness can be assumed or wrapped but this far less common.

Transferring property 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.

As mentioned above, there are certain requirements for a living trust to be a “qualifying trust” for property tax purposes. It is helpful if the deed mentions these requirements and affirms that they are met. Qualifying trusts are discussed below.

Due-on-Sale Considerations

Federal law creates a statutory living trust exception to the enforcement of due-on-sale clauses. Due-on-sale is therefore not a factor when establishing a living trust for the homestead so long as the trustor intends to continue living there. Garn-St. Germain Depository Institutions Act, 12 U.S.C. Sec. 1701j-3.

The Garn-St. Germain except does not apply to investment land trusts or trusts that do not continue to be occupied by the trustor.

QUALIFING TRUSTS FOR THE HOMESTEAD

Preserving the Homestead Tax Exemption

Living trusts for the homestead should be drafted so as:

(1) to continue to assert protections of the homestead against execution on a judgment (Texas Constitution Article XVI, Section 50 and Property Code Chapters 41 and 42); and

(2) to claim the status of qualifying trust in order to preserve homestead property tax treatment.

It is prudent for the trust agreement and the deed into trust to include qualifying-trust provisions even though Property Code Section 41.0021 states clearly that transfer of a homestead into a qualifying trust retains the homestead character of the property. Since claiming a qualifying trust homestead exemption reduces their revenue, local taxing authorities will occasionally push back. In such cases, it may be necessary to meet with appraisal district officials and show them the trust agreement.

Property Code Requirements for a Qualifying Trust

The law applicable to qualifying trusts is found in both the Property Code and the Tax Code. This is the relevant section of the Property Code:

Prop. Code Sec. 41.0021(a). In this section “qualifying trust” means an express trust:

(1) in which the instrument or court order creating the express trust, an instrument transferring property to the trust, or any other agreement that is binding on the trustee provides that a settlor or beneficiary of the trust has the right to:

(A) revoke the trust without the consent of another person other than a spouse who is also a settlor of the trust;

(B) exercise an inter vivos general power of appointment over the property that qualifies for the homestead exemption, either alone or when aggregated with property subject to an intervivos general power of appointment held by a spouse who is also a settlor of the trust; or

(C) use and occupy the residential property as the settlor’s or beneficiary’s principal residence at no cost, or rent free and without charge, except for 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 that describes the property with sufficient certainty to identify the property and that is recorded in the real property records . . . 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.

Prop. Code Sec. 41.0021(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.

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.

Tax Code Requirements for a Qualifying Trust

There is a parallel provision in Tax Code Section 11.13(j) that also applies:

Tax Code Sec. 11.13.(j). Residence Homestead [in a Qualifying Trust]

(1) “Residence homestead” means a structure [and land] not to exceed 20 acres, and improvements used in the residential occupancy of the structure . . . that: (A) is owned by one or more individuals, either directly or through a beneficial interest in a qualifying trust; (B) is [used and occupied as a] human residence . . . by an owner, by an owner’s surviving spouse who has a life estate in the property, or, for property owned through a beneficial interest in a qualifying trust, by a trustor or beneficiary of the trust who qualifies for the exemption.

(2) “Trustor” means a person who transfers an interest in real or personal property to a qualifying trust, whether during the person’s lifetime or at death, or the person’s spouse.

(3) “Qualifying trust” means [an instrument that] provides that the trustor of the trust or a beneficiary of the trust has the right to use and occupy as the trustor’s or beneficiary’s principal residence residential property rent free and without charge except for taxes and other costs and expenses specified in the instrument or court order: (i) for life; (ii) for the lesser of life or a term of years; or (iii) until the date the trust is revoked or terminated by an instrument or court order that describes the property with sufficient certainty to identify it and is recorded in the real property records.

It is common for appraisal districts to require that the trust agreement (or the deed conveying the property into trust) expressly state that the trustor may continue living in the property without paying rent or other fees.

FNMA Requirements for Trusts as 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 trustees 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 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 available online.

LIVING TRUSTS AND REAL ESTATE INVESTORS

Where is the liability barrier?

A key question when considering any entity structure is Where is the liability barrier? When it comes to trusts (standing alone) there simply isn’t one. Worse, the trustee is completely exposed since serving as trustee confers no legal protection at all (the naked trustee problem).

Adding Business Interests to the Trust

What about conveying business assets into a living trust for the homestead? Asset protection advisors do not consider this to be a good idea. As a general rule, the homestead should never be mixed together within the same trust or entity that directly owns investment real estate or other business interests. The homestead is a singular asset with unique protections in Texas. It should be kept separate from investment assets.

LLC Membership Interests in Trust

What about a trustor’s LLC membership interest? Can this safely be placed in a living trust alongside the homestead? Usually, the answer is yes if this can be done with little or no risk. This is usually the case since an LLC member does not directly own an LLC’s investment real estate.

Placing one LLC membership interest in a living trust (alongside the homestead) can serve the useful purpose of avoiding probate on the membership interest—a significant benefit and a viable approach in many situations.

Caution: as a general principle, one should not ask a trust (or any entity) to do more work than it prudently can or should be doing under the circumstances. If there are multiple assets and varied interests that need to be considered and planned for, one can always create a second trust or entity, separate from the trust that holds the homestead—and that may be the safer course.

Additional Legal Documents

A living trust is often accompanied by other documents in the estate planning category. It is good practice for the trustor to execute a last will and testament that contains provisions designed to “pour over” any assets that were not previously designated as being part of 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.

Additional estate planning documents might include a general power of attorney that qualifies as a statutory durable power of attorney under Chapter 752 of the Estates Code; a stand-alone medical power of attorney and designation of health-care agent; and an advance directive to physicians.

Conclusion

Establishing 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 should be recognized that no trust can be expected to last forever; the average lifespan of a living trust is five years or so. Changes in life circumstances may require amendments to the trust agreement over time, especially if one homestead is exchanged for another or if the names of beneficiaries change. Trust maintenance over time can be as important as trust formation.