Colorado Real Estate Transactions – What Rights are Included?

Colorado S.B. 14-009: Real Estate Transactions—What Rights are Included?

For years, landowners whose estates contain energy producing minerals have been dividing their estates into a separate surface estate and subterranean estate or “Mineral Estate.” In such areas, subsurface rights to minerals such as oil and natural gas are often severed from the surface estate, vesting ownership in multiple parties. These severances are different than others such as a wind energy right in that ownership of the mineral estate is severable from the surface estate, giving the owner of the mineral estate an exclusive right to the subterranean portion of the estate. Common ownership schemes for such an operation include the following:

  1. The owner of the undivided estate leases the mineral estate to an oil and gas company.
  2. The owner of the undivided estate sells the mineral estate to a party who then leases that mineral estate to an oil and gas company.
  3. The owner of the undivided estate sells the mineral estate to the oil and gas company.

Generally, a separate surface use agreement regulates the interaction between the owner of the surface estate, owner of the mineral estate, and leasee of the mineral estate. Such agreements commonly include conditions under which the mineral leaseholder may access the surface estate in order to access the mineral estate and whether or not compensation will be required to the surface estate owner.

Recently, with the growth of unconventional drilling technologies such as hydraulic fracturing, more landholders find themselves on land with drilling potential. Thus, more landowners are severing mineral rights to property in more densely populated and developed areas, which has the potential of creating uncertainty for a purchaser of real property.

To address this issue, the Colorado State Legislature recently passed Senate Bill 14-009. The Bill adds an additional disclosure requirement to the list of disclosures already required for conveyances of real property. This new disclosure requires a seller to provide information to a buyer regarding any potential split in ownership between the land and mineral estates. More specifically, in each contract for the sale of real property the seller must disclose the following:

  1. That the surface and mineral estate may be owned separately;
  2. Transfer of the surface estate may not include the mineral estate;
  3. Third parties may own or lease interests in oil, gas, or other minerals under the surface and may enter and use the surface estate to access the mineral estate (The use of the surface estate to access the mineral estate may be governed by a separate surface use agreement recorded with the county clerk and recorder); and
  4. The types of oil and gas activities that may occur on or adjacent to the property.

The above disclosure is intended to protect the purchaser of real property, by providing them with the information necessary to understand exactly what property rights they are acquiring when purchasing a parcel of land. By January 1, 2016 the Real Estate Commission is required to promulgate a rule regarding the above land disclosure. At that time all land subject to the real estate commission’s jurisdiction will be subject to the commission’s rule regarding disclosure. Any land not under the Real Estate Commission’s jurisdiction, will be required beginning January 1, 2016 to include, in bold typed face, a disclosure statement in any sale for real property in substantially the same form as the statutory language provided in the bill.

Changes to the Colorado Probate Code

H.B. 14-1322: Changes to the Colorado Probate Code

The Colorado General Assembly recently passed several changes to the Colorado Probate Code, which became effective August 6 of this year. In particular, House Bill 14-1322 made changes to the administration of revocable trusts. These changes include the expansion of default rules governing trust revocation and the enumeration of powers and duties afforded to certain fiduciaries acting under the terms of the trust.  

Before House Bill 14-1322, a trust could be revoked by any method expressing the “clear and convincing” intent of the trust creator (“settlor”) to revoke the trust, or if a method was expressly mentioned in the trust, revocation could be accomplished by such a method. Clear and convincing intent also included any revocation in a later drafted will or codicil that expressly referred to the revocable trust or which specifically devised property that would have otherwise passed through the trust. 

With the enactment of House Bill 14-1322, the code now requires settlors to use specific language to signal that a method of revocation is meant to be exclusive. More specifically, a trust must include the terms “sole” or “only” when referring to a method of revocation, otherwise the trust may be revoked by any other method manifesting “clear and convincing” evidence of the settlor’s intent to revoke. This change to the revocation procedure provides for a slightly higher burden on the settlor who wishes to specify an exclusive method of revocation, but also reaffirms the importance of the settlor’s intent when determining whether or not revocation is valid.

House Bill 14-1322 also adopts the statutory concepts of “trust advisors” and “directed trustees” and adds a non-exhaustive list of duties and powers applicable to directed trustees and trust advisors. A directed trustee is a person who is named in the trust as trustee, but whose actions are subject to the direction of a named fiduciary who is in charge of investment decisions on behalf of the trust. Often this named fiduciary is a trust advisor. The trust advisor will assist in the management and investment of trust property. The bill also defines the term “excluded trustees.” An excluded trustee is simply a directed trustee who, under the terms of the trust, must follow the direction of a trust advisor whereas some directed trustees have discretion over whether or not to follow the advice of the trust advisor.  

Before this Bill was passed, the Colorado Probate Code provided a set of specific and general powers in Title 15, Article 1, Part 8 of the Colorado Probate Code, which applied to all persons acting in a fiduciary capacity and which remains applicable after House Bill 14-1322. The provisions in House Bill 14-1322 allow a settlor to establish a trustee-beneficiary relationship with trust advisors, affording the trust advisor the ability to exercise the powers generally afforded to trustees and other fiduciaries. House Bill 14-1322 also imposes particular duties on trust advisors. For example, the bill explicitly states that the decisions of a trust advisor are subject to the Colorado “Uniform Prudent Investor Act.” The Bill also creates reciprocal duties among the trustee and trustee advisor, which require each to keep the other informed about the administration of the trust.

Overall, House Bill 14-1322 made several changes to the Colorado Probate Code, but for the most part they seem to clarify administrative procedures and fiduciary duties of individuals acting under a trust. If you have any questions about how these changes might affect your estate planning documents, please feel free to contact our office.

Estate Planning and Charitable Intentions

For many reasons, people are making a greater effort to make sure that their estate plan has an effect on both their own family, and a variety of charities.  The New York Times recently ran a piece entitled In Estate Planning, Family Isn’t Always First by Caitlin Kelly that said as much.  While many still aren’t making an effort to put together estate plans for the efficient administration of asset transfer at death, many, many more are at a higher rate than in years past.

It is mere speculation to think that charities have done a better job educating the populace about the benefits of giving to their organization during and after the recession.  Or, perhaps the advent of tools like Donor Advised Funds such as those offered by Fidelity, T. Rowe Price and Vanguard, have changed the giving landscape.  Regardless, clients seem to be interested in either creating a legacy or benefiting many of the same organizations they worked with closely during life, through their estate plan.

Both the client and the estate planner should have an in depth discussion about who the client is ultimately trying to benefit.  It is critically important for the estate planner to make a proper determination about the ultimate beneficiary of the client’s estate plan.  This is true if the client has a long history of giving to a particular organization, or even if the client decides that an organization is worthy of receiving their assets at death, but has never directly given to that organization.

For the sake of explanation, take this example.  If a client indicates that he or she wishes to benefit the United Way, problems could arise if the estate plan merely transfers assets at death to “United Way.”  Did the client intend to benefit the global organization, or a local chapter of the United Way?  While the answer to this question might seem obvious if the client had a long history of involvement with her local chapter of the United Way organization, it may not be obvious if she deemed them to have a worthwhile purpose that she planned to benefit with a bequest from her estate, even though she did not benefit the organization during life.

A general goal of estate planning is to inject efficiencies into the process of asset distribution at death.  Lack of clarity regarding charitable intent can make estate administration grossly inefficient.  If the Executor of the estate, or Trustee of the client’s Trust is unsure of the exact beneficiary of the estate, he or she may have to seek guidance to properly abide by their fiduciary duty under the law to properly administer the estate.  That fiduciary duty could result in request for Court interpretation of the Last Will or Trust, an inefficient process, to say the least.  The Court process could be both time consuming, and costly to all involved.

It is certainly possible to reduce the likelihood of confusion during estate planning.  A good estate plan drafter should do some homework.  Information from the client should be gathered to find out more about the organization that is to be the recipient of the client’s estate distribution.  There are times when the organization may simply not be a viable recipient of the estate bequest.  While many charitable organizations do great things, some of them are tenuously in existence, at best.  Perhaps one individual effectively runs the charity and if something happened to that person, the entity would shut down.  If this is the case, the estate planner should draft accordingly to allow the Trustee some flexibility. Perhaps the Trustee distributes assets to an alternative organization in existence at death.  Or the bequest lapses if the organization no longer exists.  All of this information can be included in the plan.

To prevent the type of confusion illustrated above in the United Way example, the estate planner should clarify the client’s wishes and investigate the organizational structure of each charity.  It could be that there is one umbrella organization where all funds are directed, but noted as benefitting a particular geographical division of the organization.  Some entities are really an amalgam of multiple regional charities that are loosely held together and merely market together without having a structural entity controlling them. 

Upon investigation, the estate planner should be able to learn how to properly draft the charitable bequest.  That bequest should include the proper legal name of the entity and its Federal Tax Identification number.   It may be helpful to the Executor or Trustee to also include a current address and phone number in the beneficiary designation.  The planner should also include directions regarding what happens if the organization either no longer exists or if it has been acquired or absorbed into a successor organization.  All of these events are very possible, especially when the plan preparation is removed by many years from the date of death.

If you have questions about how you can properly plan for charitable distributions at death, or any other estate planning questions, please contact our office.

Income Tax Consequences of Terminating a Whole Life Insurance Policy

The United States Tax Court just handed down a decision in Black v. Commissioner of Internal Revenue, T.C. Memo 2014-27, that explains what the income tax consequences are when this situation occurs.  In the opinion, the taxpayer had been the owner of a whole life insurance policy for over twenty years.  The policy had both cash value and loan features.  The policy allowed the taxpayer to borrow up to the cash value of the policy.  Loans from the policy would accrue interest and if the policy holder did not pay the interest then it would be capitalized as part of the overall debt against the policy.

The taxpayer had the right to surrender the policy at any time and receive a distribution of the cash value less any outstanding debt, which could include capitalized interest.  If the loans against the policy exceeded the cash value, the policy would terminate.  In this case, the taxpayer invested $86,663 in the life insurance policy, his total premiums paid for the policy.  Prior to the termination the total the taxpayer had borrowed from the policy was $103,548, however with capitalized interest over time the total debt on the policy was $196,230. The policy proceeds retired the policy debt at termination.

The taxpayers in this case were issued a 1099-R showing a gross distribution of $196,230 and a taxable amount of $109,567.  The non-taxable difference of $86,663 was the taxpayers’ investment in the policy – premiums paid. None of the information was included on the taxpayers’ return.  The taxpayers eventually amended their return and included as income the amount of $16,885 which represented the difference between the loan principal amount borrowed of $103,548 and the amount of premiums paid of $86,663.  Ultimately, the IRS disagreed with the taxpayers’ representation of the tax consequences of the life insurance policy termination.

The primary issue in the case then centered around whether or not the capitalized interest from the outstanding policy loans should be included in income. The Court explained that the money borrowed from the policy was a true loan with the policy used as collateral.  There were no income tax consequences on distribution of loan proceeds from the insurance company to the taxpayers.  Further, the Court explained that this is true of any loan as the taxpayers’ were obligated to re-pay the insurance company the debt owed.

The Court explained that when a policy is terminated then the loan is treated as if the proceeds were paid out to the taxpayers and the taxpayers then retired the outstanding loan by paying it back to the insurance company. The Internal Revenue Code provides that proceeds paid from an insurance company, when not part of an annuity, are generally taxable income for payments in excess of the total investment.  The insurance policy at issue treated the capitalized interest as principal on the loan. Therefore, when the policy is terminated, the loan, including capitalized interest, is charged against the proceeds and the remainder is income. This outcome makes sense or else the return on investment inside of the policy would never be taxed.

The taxpayers ended up with a large tax bill and a tough pill to swallow.  Ultimately, the result is logical in the context of capturing deferred income tax consequences.  Clearly, it would have been beneficial for the taxpayers to have consulted with counsel prior to preparing their tax return in order to avoid an unwelcome tax bill, penalties and interest.

Should you have transactions that you are unsure of when it comes to their income tax consequences, feel free to contact our office.  If you find yourself in receipt of an adjustment to your tax return based on exam action that you disagree with, or an assessment has been made and you have simply decided you were incorrect in your analysis, call us, we can help.

How Estate Tax Exemption Portability Provides Relief

Over the past decade the effective estate tax exemption has risen from $600,000 to $5.340 million for 2014.  Of course, there is an unlimited marital deduction that allows one to transfer as many assets as is desired to their surviving spouse at death.  That actually created a problem, which created common estate tax planning needs.  The problem was that each spouse had an exemption, but if all assets passed to the surviving spouse at death under the unlimited marital deduction, then the effective exemption of the first spouse to die would be unused and lost.

A common planning technique used by estate planning lawyers for years was to create a “family trust,” also called a “credit shelter trust.”  Assets would be split between spouses so that outright transfer to the surviving spouse would be avoided.  Then assets owned by the first spouse to die would be transferred to a trust for the benefit of the surviving spouse.  The surviving spouse would not have unfettered access to the funds in this trust, however the funds could be used for the health, education, maintenance and support of the surviving spouse.  This was just enough of a limitation to avoid triggering the use of the unlimited marital deduction.  As such, the exemption of the first to die’s estate would be used, rather than lost.  The effect was to basically double the amount of assets shielded from the estate tax.  Additionally, assets held in the credit shelter trust could grow, and even though they might eventually exceed the exemption amount before distribution after the surviving spouse’s death, they would never be subjected to estate tax at that time.

The above was historically very valid planning.  As the estate tax exemption rose from $600,000 to $1.5 million to $3.5 million and now going to $5.34 million, estate planners found it unnecessary to utilize the credit shelter trust technique as often.  If the exemption was $3.5 million and the total estate was $2.0 million, and the clients were elderly, it wouldn’t be worthwhile to separate assets and establish a credit shelter trust as the exemption of even one spouse would adequately shelter the entire estates of both spouses at the survivor’s death.

Even though the exemption rose, many estate plans have not been reviewed to see if the credit shelter technique is necessary.  Further, many practitioners were very hesitant to assume that the exemption would remain as high as it is now.  With the adoption of the American Taxpayer Relief Act of 2012 (the “Act”), we have stability on the exemption amount and it is tied to an inflation adjustment so it will not take an act of Congress to increase it.

Of even greater importance is that the Act adopted “portability” of the exemption between spouses.  Portability is probably one of the most efficient tax tools created in many years, though there is some room for improvement.  The basic concept is that portability allows the surviving spouse to use the deceased spouse’s unused exemption.  It is now no longer necessary to create a credit shelter trust because you can access the first spouse to die’s exemption by timely filing an estate tax return.  This is the only downside, you may have to file a return simply for the sake of portability.  Nevertheless, this is a simpler and cheaper tool than separating assets and administering a trust for the benefit of the survivor’s life.  Ideally, the government would create an easier way to elect portability than filing an estate tax return.  

From a planning perspective, our office is taking advantage of the opportunity to remove the credit shelter provisions from our client’s estate plans.  This allows for a consolidation of assets.  One objective we always have when preparing an estate plan is to seek to reduce the burden of administration at the death of the first spouse.  There is little reason in many cases to preserve the complex credit shelter provisions of an estate plan and the ongoing administration of that plan until the death of the surviving spouse.  A proactive plan is necessary as it is not possible to “un-do” the credit shelter provision after the first spouse dies.  If you have one of these plans, or have a client that has one of these plans, feel free to contact our office for a review to determine if it is possible to amend your documents to streamline estate administration for the surviving spouse and family.

Why the use of a General Durable Power of Attorney is superior to Joint Ownership with Rights of Survivorship

It may be easy to add someone as an owner with survivorship rights to your real estate or other property, but the simplicity of this action does not offset the risks associated with co-ownership. Many individuals either make the decision on their own, or with the advice of someone with practical knowledge about re-titling assets, to add a child or another intended beneficiary as the owner of their real estate, bank account, or other asset. The premise is rather simple: ownership with someone who has a right of survivorship, known as joint tenants with rights of survivorship, avoids probate at the death of the first owner, thereby leaving the surviving owner, (typically the younger intended beneficiary), with full ownership rights and no court involvement. Additionally, the objective of many is to make sure that someone, usually an adult child, has access to the original owner’s assets so that they can handle their financial affairs if that person is unable to do so on their own.

The objectives of avoiding probate at death and providing someone with access to financial means for care can be met by adding an individual as an owner to an asset. But the risks are far too high to approach these objectives in this way.

Probate avoidance at death generally involves planning that either utilizes a trust adopted by the individual owner of the asset, along with funding through transfer of assets to the trust, or, an individual may use non-probate transfer tools to make sure each asset transfers to its intended beneficiary outside of probate. Think of Transfer on Death (TOD), Pay on Death (POD), life insurance beneficiaries and beneficiary or transfer-on-death deeds. There are times when planners will utilize both a trust and a series of non-probate transfers. The point is that there are alternative methods of avoiding probate at death. These methods are used for a variety of reasons, many of which are illustrated below in a conversation about General Durable Powers of Attorney.

Adoption of a General Durable Power of Attorney (DPOA) is one of the most powerful probate avoidance tools available. Utilized during one’s life, the DPOA can authorize someone to act on another person’s behalf to make financial decisions. So, if you are incapacitated or disabled, your Attorney in Fact under the DPOA could access your checking account to pay your bills, sell your house if you were going into a nursing home, and make other financial decisions for you without a formal court order or the costs associated with that proceeding.

The General Durable Power of Attorney is a superior option to joint ownership for a variety of reasons. To begin with, when you add a person as owner of your property, that person will have equal rights to the property. This is a loss of control for you. This ownership option provides either owner with total access to the property. So, for example, if your pension or other income is deposited into a jointly owned bank account, the joint owner could legally remove 100% of that deposit for his or her individual use. Naming the same individual as your Attorney in Fact under a DPOA merely gives them rights to use your property for your benefit only. They are statutorily prohibited from using your property for their benefit. They merely have access to your property for your use and benefit, rather than acquiring any form of ownership interest allowing them to use the property for their own benefit.

From a tax perspective, it is more advantageous to continue to own the entire property in the name of the person who is thinking of transferring title. When you add an individual as a co-owner, you are actually giving them a gift equal to one-half of the value of the property at that time. If the value of the property exceeds the annual gift tax exclusion, (currently $14,000 for 2013), then you are required to file a gift tax return. Additionally, at your death, any built in gain from that part of the gifted asset will be subject to capital gains at the time your intended beneficiary sells it. This is due to the fact that the gift provides a carry over basis equal to the basis of the donor, while a death time transfer equates to a stepped-up basis to fair market value at date of death. So, if you have owned your home for 40 years and you deed half to your child, you have a basis equal to the cost of the home 40 years ago plus a variety of increases for certain improvements, etc. Likely the price has appreciated over the years and there is a built-in gain. That built-in gain merely transfers to your intended beneficiary at the time of the gift and when the home is ultimately sold, a tax will be paid by the intended beneficiary on this built-in gain. This could be avoided if the house remained in the donor’s name until death, at which point the intended beneficiary received a stepped-up basis to date of death value. This benefit most likely eliminates tax consequences presuming the home is sold shortly after date of death A similar analysis would occur for other assets, such as securities.

From a risk management perspective, joint ownership is objectionable because your assets become subject to creditors of the co-owner. So, if you add a child as owner of your home or bank account and that child is going through a divorce or has judgments outstanding to creditors, your asset could be used to satisfy those creditors. Furthermore, as joint owners, you could be held responsible for the other owner’s actions while using a jointly owned asset. Probably the most common example here would be a car accident where you get sued for being a co-owner of a car you weren’t even driving.

From a business owner’s perspective, joint ownership is particularly problematic for risk management. If the business operates as a sole proprietorship, adjusting ownership so that an intended beneficiary is a co-owner creates many negative tax consequences and the entire business operations could become subjected to the liabilities of the new co-owner. Should that new co-owner file for bankruptcy, the bankruptcy trustee will have a high level of interest in the operations of the business venture to determine how it’s cash flow and assets can satisfy the new co-owner’s debtors. Fundamentally, it is also possible to alter ownership interests in corporations, limited liability companies and other business organizations. Similar risk is involved in that new co-owners bring a whole host of potential creditors and liabilities that could affect the viability of the business in an unintended way.

The adoption of a General Durable Power of Attorney, in combination with a review of business operation documents, such as bylaws, operating agreements, buy-sell agreements, etc., could effectively protect the business from involvement by the Court if an owner is incapacitated and can’t function on their own. It would likewise eliminate concern for the above issues as created by a joint ownership situation.

Should you have questions about General Durable Powers of Attorney for your personal or business situation, please don’t hesitate to contact our office.