Recently, I wrote an article about how to use debt as a tool in estate planning. Today, I will provide you with a specific example of how to accomplish that by discussing how a trust can make a private loan to the beneficiary of the trust.
Imagine this scenario. Mom and Dad die, leaving their son, Sam, $3,000,000 in a lifetime trust. Bill is married to Jenny. Bill and Jenny want to buy a house together and planning to start a family. Jenny has some student debt and a mediocre credit score. The couple is in their late twenties and can’t afford a nice house based upon what they are earning. They wish to purchase a house that costs $400,000. However, they have only saved enough for a $20,000 down payment. Bill knows he has a trust for his benefit, so he asks his trust attorney what his options are.
Common Ways a Trust Can Distribute Funds
The trust that Bill’s parents prepared happens to be very flexible. One option, according to the trust, is that the trustee can help Bill and Jenny with mortgage payments. However, that is not a suitable option for the young couple. Since Jenny doesn’t have great credit and has a lot of student debt, they would be borrowing at a very high interest rate. Moreover, they may not qualify for a large mortgage.
Another option is that the trust could buy the property, and then they could live there together. Jenny doesn’t feel comfortable with this option. Since she is not a beneficiary of the trust, if something happened to Bill, she would be kicked out of her own home.
Jenny asks if the trust can simply give them the money so that they can buy the house. While the trust gives the Trustee discretion to do this, Bill doesn’t like that idea. He has seen a few of his friends get divorced. He knows that if the trustee distributes the funds to them, and the house is purchased in both of their names, there is a strong likelihood he will lose half of the equity.
The final option is that the trust can act like a private bank and lend Bill and Jenny the money. The trust can loan Bill and Jenny $380,000 (or the full $400,000). It can also do so at a very low rate of interest. Bill and Jenny will need to pay the loan back to the trust, but the deal can be structured over any length of time they wish. Moreover, Bill and Jenny can legitimately tell the realtor that they are able to buy without a mortgage contingency since the trustee will have pre-approved the loan by this point. This gives Bill and Jenny even more flexibility and buying power.
Legal Authority for a Trustee of a Trust to Make a Private Loan
The trustee of a trust can only act within the scope of the powers given to them. However, most modern trusts tend to be very flexible. Most well drafted trusts permit the trustees to make loans on any conditions that they deem reasonable. Accordingly, as long as the trust has this type of language, the trustee generally will be able to make a private loan to the beneficiary of the trust (as well as that beneficiary’s spouse).
A trustee and the beneficiary should keep in touch with each other on a routine basis. The trustee must manage the trust for the benefit of all the beneficiaries. In the example above, you may think that the only beneficiary is Bill. However, since it is a lifetime trust for his benefit, the trustee must also look out for the interests of Bill’s potential descendants. The practical implication of this is that the trustee shouldn’t loan Bill and Jenny the entirety of the trust. Just a portion. It will be up to the trustee to consider what is right based upon all the circumstances.
By making a loan to a beneficiary rather than an outright distribution, the trustee is better protecting the principal of the trust. In the example above, let’s assume Bill and Jenny got divorced. When the house is sold, the trust would be paid back first before the rest of the proceeds were split between Jenny and Bill. As long as the private loan is recorded with a mortgage, it is generally a very safe transaction for the trustee. (Note: the trustee does not have to require a mortgage, but in this situation we would recommend it.)
Mechanics of a Private Loan Using a Trust
The starting point for any transaction like this is to review the trust document. An attorney should confirm whether the trustee has the authority to make a private loan. The next question is determining what amount, if any, would be appropriate. The trustee must consider factors such as the overall value of the trust, who are all the current and contingent beneficiaries, the amount of the loan, and the beneficiary’s ability to repay the loan. If the trustee is also the beneficiary, consider whether a neutral trustee should be appointed.
After all the parties agree to the amount of the loan, then they must consider the terms. This includes the length, how often payments must be made, and of course the interest rate. We strongly recommend that the interest rate be above the minimum amount set forth by the IRS to avoid triggering a deemed gift. (If the rate is too low, the IRS could say that the beneficiary is making a gift to his own trust. That could be disastrous from a tax perspective.)
The trust attorney could potentially draft any legal paperwork required for the loan. Then, at the time of the closing, the trustee would have Bill and Jenny sign a private promissory note and a mortgage, and wire money to the closing agents.
The final step is to arrange for payments to be made back to the trust according to whatever schedule was agreed upon. We strongly recommend considering what will happen if the beneficiary is late with payments or stops paying entirely.
The loan given to Bill and Jenny should not be subject to any tax. Interest paid on a loan used in the purchase of one’s primary home is generally tax deductible. Accordingly, when Bill and Jenny pay back income to the trust, they are entitled to receive an income tax deduction. The trust, in turn, will be required to report income.
Because the home is owned in Bill and Jenny’s name, rather than the name of the trust, it will qualify for a capital gains tax exclusion if they wish to sell it. This is another argument in favor of having the trust make a private loan rather than buying the property outright.
Other Reasons a Trust Can Make a Private Loan
Other ways that this same technique can be used include:
- Refinancing an existing mortgage to a lower rate and on better terms
- Making a loan to a beneficiary to start a business (or for other business opportunities)
- Providing a bridge loan
- As a way to pay for school (although usually outright distributions are made for this purpose)
- Buying collectibles
There is a significant growth in the number of individuals creating dynasty trusts. If you are a beneficiary of a lifetime trust or a dynasty trust, we strongly recommend that you consult with a trust attorney to understand all of your rights.