A Man’s Home Is His Castle…Or Is It?

Homemade Homestead Protection

Dear Clients, Colleagues, and Friends,

Saul can’t sleep.

He has a reputation for attention to detail, but he forgot something, he just knows it. Saul probes his memories, thinking back over the past several months to parse out what could possibly be bothering him…

Saul sold his company for a huge pile of cash two years ago. A smart guy, he knows how to protect his assets. That’s why, on the advice of counsel, he put most of the cash he received from the sale of his company into an offshore asset protection trust (APT). He understood that if anyone ever came after the cash, it would be out of play inside an APT. Then, he decided to splurge on one extravagant, lifelong goal: to build his very own dream beach house.

After an extensive search, taking a withdrawal from his APT, Saul paid cash for a lot with “drop dead” gorgeous Pacific Ocean views that literally took his breath away. An award-winning architect designed a magazine-ready masterpiece that magically propels beach breezes throughout the house even on the most stifling days. The house is a sanctuary, full of brightly lit reading nooks and comfortable places to catch a nap. After being featured in Architectural Digest, Saul’s second proudest achievement with his showstopper home is that it is 100% family friendly, designed with his kids’ and grandkids’ enjoyment in mind. After all, he wants his family to benefit from this fabulous beach property forever, even after he’s long gone.

As Saul spends his first night walking through the beautiful, breezy house thinking of all he has accomplished and why he can’t sleep, it hits him… he protected the cash he received from the sale of his company but not his newly purchased real estate. With dawning realization, he understands that his dream house is not part of the APT – and it can’t be – because real estate can’t just be picked up and moved into an offshore trust.

Mystery solved, Saul still can’t sleep, wondering what he can do to protect the beach house from future creditors, kids’ divorcing spouses and any other evil force determined to take from the rich and give to the less advantaged. To top off his list of worries? Those ever-lurking death taxes.

Saul’s mental calculator works overtime. He invested $15M in the new beach house. Surprisingly, he has already received several unsolicited, all-cash offers from foreign investors to buy the estate for more than $20M. At this rate, by the time he dies, the beach house could be worth well over $50M. At a 40% death tax rate, his kids could owe $20M+ to the IRS and his survivors would be forced to sell assets to raise the cash. Saul wants to keep this masterpiece protected from future lawsuits and never wants it to be sold – ever – so the kids and grandkids will have this fabulous property to use for generations. Can he accomplish that? It feels overwhelmingly impossible with the current state of the law.

As an estate and trust law firm, one of the questions our clients most often ask is how to keep both the primary and vacation homes in the family and protect them from future lawsuit creditors.

Because California has a miserly primary residence homestead exemption, and no exemption for vacation homes, the planning options for dealing with an expensive personal residence or vacation home can be boiled down to two options: a qualified personal resident trust (QPRT) or a promissory note residence trust (PNRT), each of which have their place in the planning process.

Qualified personal resident trusts have gained popularity over the past 20 years because they can be established as an irrevocable trust in which the parent retains the right to occupy the house for a predesignated “term of years,” after which time the residence belongs to the children. If the parent survives the term of years, the date of death value of the property is excluded from death taxes, but if the parent dies before the term expires, the entire value of the property is subject to death taxes. The QPRT also provides some asset protection because future judgment creditors are only entitled to take the remaining term of years, but not the remainder interest earmarked for the children. This split interest is not particularly attractive to prospective creditors; therefore, the residence might not be a very viable target.

Saul considers the advantages of the QPRT, but dislikes the term of years gamble and the idea that lawsuit creditors could still take away his ability to live in the house, even though his children would be protected.

Saul asks his counsel if there is an asset protection structure that creates a “homemade homestead.” Saul’s counsel describes a relatively new estate planning and asset protection trust which has many unique advantages over the QPRT. Called the promissory note residence trust (PNRT), simply stated, it involves the sale of the personal residence or vacation home to an income tax defective grantor trust, such as the HYCET™ Trust often described in past CLIENT ALERTS, in exchange for a promissory note.

Here’s how it works:

Saul funds the PNRT with some cash or other property via a gift, giving the Trust an initial balance sheet. He then sells his residence or vacation home (or both) in exchange for an IOU or promissory note (up to nine times the funding amount) from the Trust, which is secured by trust assets. Saul can continue to live in his property, but he must pay rent at market rates to the PNRT. The PNRT then pays Saul interest on the promissory note he holds, which usually covers the rental payment, making it a zero sum game. Due to the grantor trust status of the PNRT, these transactions are federal and state tax-free for Saul. The note term is quite flexible, ranging from 3 – 20 years in duration, and the principal of the note can be prepaid without penalty.

There are several advantages of using a PNRT. All future appreciation of the beach house remains in the PNRT, free of estate and generation skipping tax for a period of time exceeding 360 years (although the IRS wants to change this rule, so act soon before the rules change). If the promissory note remains outstanding at Saul’s death, it will be included in his estate; alternatively, he can use a self-canceling installment note which expires at his death and is not includable in the estate. If estate taxes do become due on the promissory note, the PNRT can purchase a life insurance policy on Saul to cover them. The PNRT can also purchase real estate for the kids and grandkids without having to charge them rent for the use and enjoyment of the property. In sum, the PNRT can avoid death taxes and provide solid creditor protection.

Upon the advice of counsel, Saul decides to take advantage of a PNRT. He instructs his lawyer to establish the PNRT and fund it with some of the cash he tucked away in his APT. Once the PNRT’s trustee purchases his beach house, Saul will be issued an IOU for 20 years and put it into his APT for safe keeping. He pays rent to the PNRT and the PNRT pays Saul interest on the note. Saul’s beach house is now nicely tucked away and protected from potential lawsuits, estate taxes at his death, bankruptcy, IRS liens, creditors and divorcing spouses of his kids and grandkids.

Saul can finally sleep at night knowing that there is a legal, homemade homestead protecting his family.

If exposed real estate assets are keeping you up at night, and you would like to learn how the PNRT can work for you, please contact our office to schedule a consultation with one of our professionals.

Posted in Client Alert, Scenario.