Trust Fund Loophole - Stepped-up Basis

During President Obama's recent state of the union address, he proposed, amongst other tax recommendations, to "close the trust fund loophole." The trust fund loophole he was alluding to is the "stepped-up basis" assets receive when a person inherits them.

The term "trust fund loophole" is a slight misnomer because all inherited assets receive a stepped-up basis. If a person dies with neither a will nor a trust, their heirs nonetheless receive a stepped-up basis for the assets they inherit from the decedent. There is no requirement that assets be held in trust in order to receive a stepped-up basis. Many past clients have been beneficiaries of an estate where the decedent did not have a will or trust. Presumably "trust fund loophole" was used for messaging reasons because tax terminology is regularly obscure and dull. 

The stepped-up basis, as presently constituted, works as follows. (this example is a hypothetical). In 1980, John Smith purchased a home in the Almond Grove district of Los Gatos, CA for $100,000. In 2010, Mr. Smith wrote a trust and funded the trust with his property by executing and recording a grant deed with Santa Clara County. In 2015, Mr. Smith passed away in a tragic hot air-balloon accident. The successor trustee then had the property appraised for $1M. If the property is sold by the successor trustee for $1.1M, the capital gains tax is generally on the $100,000 gain. The reason is that when Mr. Smith passed away, the property received a new basis that is pegged to the value of the property on Mr. Smith's death, i.e. $1M. See IRC § 1014. For example, if Mr. Smith passed away on January 15, 2015, the reference point for the appraisal of the property would also be January 15, 2015.

President Obama's proposal is to eliminate the stepped-up basis. Under this scenario, the sale of Mr. Smith's property would result  in a capital gains tax on the $1M gain. The reason is that there is no stepped-up basis, so the selling basis is the same as Mr. Smith's acquisition basis, $100,000. Hence, all the appreciation in Mr. Smith's home which previously escaped taxation would now be taxed. 

This blog offers no opinion on the strengths and weaknesses of this proposal. This post is strictly for informational reasons. Please do not contact me with your political viewpoint(s) on the matter. I am not affiliated with Congress. Thank you.

Litigation involving a Decedent

When a person passes away, the law does not automatically grant them immunity from civil litigation. A cause of action survives the decedent's death. 

For example, assume the decedent prematurely broke a fixed-term lease because he wanted to follow the summer tour of the Grateful Dead (assume they are still touring). The landlord vowed to sue the decedent once he returned from his vacation. When the landlord returned from vacation he discovered that his former tenant had passed away in a tragic hot air balloon accident (the Grateful Dead were not playing that day). Normally the landlord would have 4 years to commence suit against his former tenant. CCP § 337.2. However, since his tenant passed away, the time limit changed.

CCP § 366.2(a) reads "If a person against whom an action may be brought on a liability of the person, whether arising in contract, tort, or otherwise, and whether accrued or not accrued, dies before the expiration of the applicable limitations period, and the cause of action survives, an action may be commenced within one year after the date of death, and the limitations period that would have been applicable does not apply."    

So the landlord now has 1 year to file suit rather than 4 years. If the landlord does not timely file suit, his claim is time-barred and is subject to dismissal with prejudice. That is, the landlord could not re-file his suit at a later time.    

This 1 year time limit is known as the statute of limitations. 

Many people ask if they can sue for some hypothetical reason. The answer almost always depends on what type of action they seek to file suit. One cause of action, personal injury or wrongful death, has a 2 year statute of limitation. CCP § 335.1. Another cause of action, trespass or injury to real property, has a 3 year statute of limitation. CCP § 338. What makes CCP § 366.2 unique is that it overrides the statute of limitations of the other statute. As mentioned above, the landlord would have 1 year to sue instead of 4 years because the tenant passed away before he filed suit. In other words, CCP § 366.2 trumps CCP § 337.2.

For reference "CCP" stands for the California Code of Civil Procedure. It can be found here 

http://leginfo.legislature.ca.gov/faces/codes.xhtml

Ambiguous Terms in a Trust - Extrinsic Evidence

Occasionally a person will write a trust with an ambiguous distribution clause. That is, the clause is open to reasonable multiple interpretations. The determination of the rightful beneficiary is obviously paramount because no distribution can be made until the right beneficiary is determined. Absent a settlement agreement, you cannot just split the inheritance between the two beneficiaries.

California law says that in such a situation, extrinsic evidence can be introduced to construe the ambiguous clause. Ike v Doolittle (1998) 61 CA4th 51. Extrinsic evidence is documentation found outside the instrument in question used to determine intent or construction of the instrument. For example, this could be written statements made by the person in the past.

The following example is how an ambiguous clause in a trust could be resolved.

Alf Melmac was an avid surfer who dreamed of catching that perfect wave. All of Alf's free time was dedicated to surfing along the long and beautiful California coast. Alf was quite wealthy so he decided to write a trust after hearing about the drawbacks of probate. Alf was also quite philanthropic and decided to bequeath his entire estate to his favorite surfing spot. 

The problem was that Alf used the term "Surf City, U.S.A." when designating the sole beneficiary of his trust (he wrote the trust himself). In particular, two cities in California lay claim to such a nickname, Santa Cruz and Huntington Beach.  

In light of the ambiguity, extrinsic evidence was needed to ascertain which "Surf City, U.S.A." was the rightful beneficiary of Alf's estate, Santa Cruz, CA or Huntington Beach, CA. Amongst Alf's personal effects were journals talking about his many surfing experiences while in Santa Cruz. He also mentioned running in Santa Cruz's annual Wharf to Wharf fun run held on the last Sunday in July. While he had surfed Huntington Beach, he had surfed Santa Cruz far more times. Thus, Alf's estate was distributed to Santa Cruz, CA instead of Huntington Beach, CA.   
 
A real life example of a person writing an ambiguous distribution clause occurred in Estate of Black (1962) 211 Cal.App.2d 75. In that case, Coral Williams of Los Gatos, CA wrote a holographic will with the following clause:

"To The University of Southern California known as The U.C.L.A. My entire Estate for Educational purposes.”

Whoops. 

Naturally the case was litigated between the two schools, i.e. the University of Southern California and the University of California, Los Angeles. 

The Other Prop 8

Many people are familiar with Prop 8, the gay marriage ban passed in 2008 by California voters which was ultimately ruled unconstitutional. However, unknown to many, there is another Prop 8 which was also passed by voters, albeit in November 1978. Unlike the latter Prop 8, the prior Prop 8 lacks the same amount of controversy. I can assure you of this. The prior Prop 8 was passed because California voters passed the landmark ballot initiative Prop 13 in June 1978.

In short, Prop 8 allows for the county assessor to assess the property below the Prop 13 value if the home's value is below the factored base year value, i.e. the Prop 13 value. The following example illustrates the interplay between Prop 8 and Prop 13.

Theo Chambers purchases a home in Campbell, CA in July 2008 for $600,000. The assessed value under Prop 13 can be raised at most 2% per year. Thus for 2009, the maximum assessed value for 2009 that Santa Clara County can impose under Prop 13 is $612,000. 

Theo unfortunately purchased his home just prior to the great recession. Real estate prices naturally suffer a precipitous drop. In Theo's case, his home depreciates $150,000 in value in the ensuing months. When January 1, 20009 rolls around, the market value of his home is $450,000. Due to Prop 8, Theo's assessed value will also be $450,000, rather than $612,000. So when Theo pays his property tax bill, it will be derived from the $450,000 assessment.

Years later, the real estate market recovers and home prices increase to levels greater than or equal to the prerecession levels. Consequently, Theo's home is now worth $750,000 in 2015.

Santa Clara County can now assess Theo's property under Prop 13 because of the appreciation. However, it cannot assess Theo's property at $750,000 because it has not reached that level under Prop 13's annual 2% increase. A 2% increase from 2009 to 2015 yields an assessment of roughly $690,000. Thus, Santa Clara County will use the $690,000 assessment for Theo's property taxes.    

Another salient point is that in times of significant real estate appreciation, the assessor can increase the assessment greater than 2% in consecutive years under Prop 8. For example, assume a home is purchased for $100,000 in 2013. Home values plummet because of a derailed train carrying crude oil that pollutes the entire town. This results in the home losing $50,000 of its value in 2014. Prop 8 kicks in and the assessment is $50,000. Yet in 2015, a wealthy philanthropist donates tens of millions of dollar to the city to revitalize it and home prices rebound immensely, such that the value of the home is now $125,000. The county assessor can now roughly increase the assessment $54,000 because the Prop 13 value is less than the market value. That is, the 2% increase of $100,000 from 2013 to 2015 results in roughly a $104,000 assessment. Therefore, the property taxes will be based off of the assessment of $104,000, not $125,000.

Notary changes in 2015 - SB-1050

When a notary acknowledges a document, the verbiage in the notary block is statutorily required to contain certain information.  For example, the California Civil Code specifies what must be in an acknowledgement and what must be in a jurat. In the case of an acknowledgement, previously the notary block was as follows: 

State of California

County of __insert county___

On __insert date___ before me, __insert notary's name___, __insert title, e.g. Notary Public___, personally appeared __insert signatory's name__, who proved to me on the basis of satisfactory evidence to be the person(s) whose name(s) is/are subscribed to the within instrument and acknowledged to me that he/she/they executed the same in his/her/their authorized capacity(ies), and that by his/her/their signature(s) on the instrument the person(s), or the entity upon behalf of which the person(s) acted, executed the instrument.

I certify under PENALTY OF PERJURY under the laws of the State of California that the foregoing paragraph is true and correct.

WITNESS my hand and official seal.

Signature ______________________________ (Seal)

In light of the SB-1050's passage, effective January 1, 2015, the notary block must now contain a legible disclaimer at the top of the acknowledgment in a box that reads:

"A notary public or other officer completing this certificate verifies only the identity of the individual who signed the document to which this certificate is attached, and not the truthfulness, accuracy, or validity of that document."

Therefore, for an acknowledgement and a jurat executed now and hereafter, the notary block must contain the two above aspects. Otherwise, the notary is invalid for failing to comply with statutory formalities.

For reference, this new law did not change the amount a notary can charge per signature. The maximum fee remains at $10. Furthermore, it should be noted that this $10 fee is per signature. It is not per visit with the notary. For instance, if a husband and wife are closing a home purchase and 14 signatures are needed, the notary charge up to $140 (14x10). The notary is not required to charge only $20 or $10. I had to convey a similar sentiment to somebody who called my office and needed such done.

Conversely, the notary is not required to charge a fee at all. The notary can simply to do it charitably although the only cases I have heard about a notary doing this is for family, friends or the attorney is a notary who notarizes documents for a client (myself).