A “living trust” (sometimes called a “loving trust”) is a special legal entity that you create by preparing and executing a formal trust document, declaring that you are holding certain property “in trust.” You retain the right to “revoke” the trust at any time, or to take the property back out of the trust.
Because the trust is revocable, it is treated as a fictional entity during your lifetime. You pay taxes on any trust income during your lifetime, and your creditors could seize trust assets to pay your debts.
However, at your death, the trust becomes irrevocable (since you are no longer around to revoke it), and takes on new life as a truly separate legal entity. Any property owned by the trust is not subject to probate, because it is not owned by you or your estate at all. However, the probate court has authority to resolve disputes about the trust, and the trust usually remains liable for your debts (including any estate taxes).
If a husband and wife jointly create a revocable trust, then when one spouse dies, the trust is usually split into two parts: one contains the surviving spouse’s property, and remains revocable, while the other part is irrevocable and is usually earmarked for the use of the surviving spouse, with any balance remaining at the survivor’s death passing to the couple’s children. However, many different trust arrangements are possible, each with differing legal and tax consequences.
If you properly transfer your property into a revocable trust, then your estate will not need to pass through probate at your death. A carefully-drafted living trust can also serve to reduce or eliminate federal estate taxes, but it is important to recognize that any estate-tax benefits available through a “living trust” can also be obtained by an equally-carefully-drafted will. (A will, however, is subject to probate.)
If you fail to properly transfer assets into a trust, you may lose the benefit and your estate may be subject to probate anyway. For example, if you fail to transfer your home into the trust, it will be a probate asset after both spouses have died.
If the living trust is split after one spouse dies, additional accounting work will be needed, and each irrevocable trust must file its own tax return.
How Refinancing May “Undo” Your Trust
When interest rates plunged in the past few years, many homeowners took advantage of the lower rates by refinancing their homes. Unfortunately, most lenders are still reluctant to make loans on property held by a living trust, primarily because lenders are very conservative and reluctant to change their ways. As a result, homeowners were often required to transfer the home from the trust back to the owners’ individual names, before the new loan was made and a deed of trust recorded.
After the new loan was made, the homeowners were free to transfer the home back into the living trust, in order to preserve the probate-avoidance benefit. However, lenders rarely assist homeowners with this final step, and often the homeowner does not even realize that the home was removed from the trust as part of the mortgage refinancing transaction, since that deed was one of many documents signed in a short time.
The end result is that thousands of California homeowners, who properly transferred their homes into their revocable living trusts to avoid probate, may face probate anyway because their work was undone.
While it is often possible to obtain court approval to confirm trust ownership of a home if it was never formally transferred to the trust, it is very unlikely that a court would confirm trust ownership if the last document signed was a deed transferring the property out of the trust and into the owners’ individual names.
If you or any of your family members or friends implemented a “living trust” and subsequently refinanced your home, it is important to review the documents to make sure that the home is currently held in the name of the living trust. If not, you should prepare and record a new deed returning the property into the name of the trust.
As a backup measure, I sometimes recommend that clients execute a new “Declaration of Trust” annually, confirming that all their property is held by them as trustees of their revocable living trust, regardless of the formal title arrangements.