How to Protect Your Personal Residence Using an IDGT (Intentionally Defective Grantor Trust)
No estate plan or financial plan can be complete if it does not incorporate asset protection. And one of the most difficult assets to protect is your personal residence. It is also usually one of the most valuable assets of many clients and therefore should be protected. Keep reading and you’ll learn how to protect your personal residence.
Traditional Personal Residence Protection Tools
Here are the most common tools for protecting your personal residence.
1) Homestead Exemption. As of January 1, 2022, the homestead exemption in Arizona (regardless of if you are married or single) is $250,000 for the homestead. However, as of January 1, 2022, Arizona’s homestead exemption no longer protects against judgments.
In contrast, Iowa, Texas, and Florida protect the entire value of the home from creditors through state statutes (with limitations of the new bankruptcy laws). Other states protect the personal residence to varying degrees.
2) Qualified Personal Residence Trust (QPRT). A QPRT is an irrevocable trust with unfavorable terms. There are probably better options for protecting the home.
3) Equity stripping. This concept can work out very well from a financial and asset protection standpoint when done right (which is rare). We recommend equity stripping when it is a good fit for you financially. Equity stripping is not for everyone with equity.
4) Limited Liability Companies (LLCs) (multi-member). Some undereducated advisors recommend that a client use one to protect the home. The problem with such advice is this. First, you lose the mortgage deduction. Second, you could lose the $250,000 per spouse capital gains tax exemption. (You must own the house in his/her own name for 2 years out of 5 to use the exemption.) Third, your property tax may increase because you can’t claim the residence as a homestead.
5) Umbrella Insurance. We always recommend getting personal umbrella insurance. However, it will not cover allegations (whether true or not) of the following: intentional acts, criminal behavior, damage caused while you are performing business activities, or damage from certain dogs or vehicle types.
So, now let’s discuss how to protect your personal residence using an Intentionally Defective Grantor Trust (IDGT).
What is an IDGT (Intentionally Defective Grantor Trust)?
An intentionally defective grantor (IDGT) trust is an estate-planning tool that is used to freeze certain assets of an individual for estate tax purposes, but not for income tax purposes. The intentionally defective trust uses a tax loophole that allows the grantor (the person who creates the trust) to continue paying income taxes on certain trust assets, as income tax laws will not recognize that those assets have been transferred away from the individual. It can include a “switch” so that the grantor can choose who is responsible for income taxes … either the grantor or the trust beneficiaries.
Because the grantor must pay the taxes on all trust income annually, the assets in the trust are allowed to grow tax-free, and thereby avoid gift taxation for the grantor’s beneficiaries. Thus, it is a loophole used to reduce estate tax exposure.
You can use an IDGT to reduce capital gains, income, estate, and gift tax. Even so, this discussion will focus on how to use an IDGT for “asset protection.”
How Can an IDGT Protect Your Personal Residence?
The basic rule when it comes to protecting yourself and your family from creditors and lawsuits is this:
What You Don’t Own Can’t Be Taken from You.
There is a specific way that you should transfer your personal residence to your IDGT. That is discussed below. But assuming you do properly, your personal residence is not in your name.
Properly Transferring your Personal Residence to an IDGT
Below is a flow chart for how to set up and use an IDGT. For purposes of this discussion, you need to know that, as a general statement, an IDGT is a disregarded entity for tax purposes when the grantor (person creating the IDGT) is making the transfer to the trust.
What really happened? You sold your residence to the trust and entered into a lease with the trust to live in it. You pay X dollars to the trust as rent and the trust pays back to you Y dollars via the installment note.
Getting the Capital Gains Exemption
Since you are not the “owner” of the house, you won’t qualify for the Section 121 exclusion from capital gains upon the sale of your house. Normally, if you owned the house in your personal name, and lived in it two out of the last five years, you could avoid capital gains tax. But that’s not available if the house is in an irrevocable trust.
Here is one solution to this. (By the way, this needs to be thought through ahead of time when the trust is drafted.) First, you could have the Trust Protector amend the trust retroactively to make it revocable. That obviously erases any asset protection while it is revocable. But you can avoid the capital gains tax. Then after the house sells, you can convert the trust back into being irrevocable.
Frequently Asked Questions
Here are some questions that you might have before you decide protect your personal residence with an Intentionally Defective Grantor Trust (IDGT).
I don’t like the idea of naming someone other than me as the beneficiary. Can I have both protection AND control?
Yes. The protection comes from the fact that your house is no longer in your name, and you are not the beneficiary of the IDGT.
You maintain control in a couple of different ways. First, you get to choose a Trust Protector. That is a neutral third party who has the ability to replace the trustee, change the terms of the trust, name you as the beneficiary (thus turning your IDGT into a simple living trust), and even unwind the trust.
In this way, you get to choose who your trustee is. If the initial trustee is not doing what you want, you can simply find a replacement.
The second way you can have control is to include a Special Power of Appointment. That is a provision that allows you to instruct the trustee to transfer the trust property to anyone other than yourself. And before you start rolling your eyes, just consider the power of this. To get creditor protection, you can’t have the power to retransfer the trust property back to yourself. However, you can transfer it to a close friend, your parent, or anyone else that you trust to then turn around and transfer the property to you.
Is the rent deductible to the client?
No.
Is the rent income to the IDGT?
No.
Is the installment note payment to the client from the IDGT income to the client?
No.
Can the note be accelerated?
Yes. If the client ultimately would like the house sold, that can be accomplished in the IDGT and the proceeds can be paid to the client through an accelerated installment note payment.
What happens if the property has a mortgage?
The IDGT would make the mortgage payments which would still be deductible to the client/grantor as if the house is owned individually.
Why not just use a Land Trust?
A Land Trust provides zero creditor protection. Zilch. It can provide a level of privacy (as long as you don’t lose a lawsuit and get compelled to disclose your assets). Hiding behind a paper wall also provides some privacy, but it does not provide protection. If you ever lose a lawsuit, the law provides an easy way for your judgment creditor to access your assets (including your house) held by a Land Trust.
Oh, and Arizona (like many other states) does not recognize Land Trusts. In Arizona, a Land Trust is treated like what it is … a revocable living trust in which you have named a trustee other than yourself.
Summary of Intentionally Defective Grantor Trusts
An IDGT (Intentionally Defective Grantor Trust) is one of the most powerful tools for protecting your personal residence. But it has to be done properly.
This blog post does not provide all the details for how to protect your personal residence using an IDGT (Intentionally Defective Grantor Trust). Instead, this is simply meant to make you aware of the fact that an IDGT can be used for that purpose.
If you have wealth and significant equity in your homes, schedule a Strategy Session with one of our attorneys to discuss with you how to protect your home’s equity.
