July 12, 2018
1. Inspecting and Purchasing Real Property.
a. Investment strategy.
i. The trustee should develop an investment strategy which may incorporate ownership of real property and should comply with the prudent investor rule unless such rule is explicitly waived in the trust document.
ii. Any ownership of property should bring the trust portfolio into compliance with the trust’s purposes, terms, distribution requirements and other relevant circumstances.
iii. The investment strategy should also consider the beneficiaries’ needs and any specific instructions or priorities outlined in the trust document.
iv. The trustee’s strategy should consider the risk-reward associated with real estate ownership. Advantages include cash flow (income/rents), increased diversification, inflation hedging. Disadvantages include ongoing management needs, carrying costs, transaction expenses, regulatory and environmental headaches.
b. Authority to transact.
i. The trustee should ensure that the trust document permits investment in the particular type of property being purchased. Most standard trust forms explicitly allow for this, as does default California law. CA Probate Code § 16226.
ii. The trustee may have to provide evidence of the trustee’s authority to sign documents on behalf of the trust by preparing a certification of trust (CA Probate Code § 18100.5) which establishes, for the benefit of third parties, the trustee’s roles and authority.
c. Duty to inspect.
i. The trustee should ensure that all normal and reasonable inspections necessary to evaluate the property’s condition and viability are conducted prior to sale.
ii. Special attention must be paid to potential environmental liabilities.
2. Maintaining Adequate Insurance and Cost-Effective Liability Protection.
a. Trustee has a fiduciary duty to protect trust property.
i. This means that all property should be insured if such insurance is commercially reasonable.
ii. Failure to properly protect property may result in the trustee’s personal liability for damage to trust property.
b. Must obtain sufficient casualty and liability insurance per normal practice.
i. Consider specialty insurance like earthquake and flood insurance.
ii. If earthquake insurance is unobtainable, consider nonrecourse debt as substitute.
iii. Any premiums are proper expenses of the trust. CA Probate Code § 16240.
c. Consider obtaining appraisals to ensure adequate insurance protection.
d. Create wholly-owned entities for further liability protection.
i. Separate entities may be used to insulate each property from liability.
ii. Beware of the CA gross receipts tax on LLCs, which subjects LLCs to taxes of up to $10,000/year, depending on the entity’s gross receipts. Consider LP/LLC structure instead, with the LP being 99.9% owned by the trust, with 0.1% owned by the LLC (who acts as the GP of the LLC), and the LLC being wholly-owned by the trust. Both the LP and LLC in this case would be disregarded entities for tax purposes.
3. Avoiding and Managing Environmental Liability.
a. Liability for cleanup of contaminated trust property.
i. Liability exists under various federal and state laws, including CERCLA, Clean Water Act, Toxic Substances Control Act, amongst others.
ii. Liability is generally based on status (i.e., as titleholder) not on responsibility.
iii. If a decedent was personally liable under one of the above-listed laws, the liability may flow through to the trustee, even if the trust does not hold the contaminated property. This is called the “trust fund” theory.
iv. Fiduciary exemptions from liability.
1. Liability may not exceed the value of the trust estate.
2. The trustee is not personally liable for responsibility to cleanup and deal with contamination, pursuant to statutory protections in acts like CERCLA. 42 USC § 9607(n)(4). Also note such protections exist under CA law, such as in CA Health & S. Code § 25548.3.
b. Options for protection:
i. Create reserve of trust assets.
ii. Obtain indemnification from beneficiaries.
iii. Obtain protective court order.
iv. Use of creditor’s claim procedure to cut off period for claims.
v. Entity formation.
4. Delegation of Management Authority and Trustee Duties.
a. Trustee may delegate investment and management functions if prudent. The trustee may therefore delegate property management responsibilities to property management professionals.
b. Duty to protect and manage trust property includes duty to supervise property managers and all other agents.
c. Property management fees must be reasonable and there can be no conflict of interest (i.e., it is best that the property manager not work for or be associated with the trustee unless such an arrangement is approved in writing by all the trust beneficiaries).
5. Maintaining Real Property vs. Duty to Diversify.
a. Review of Trust Assets and Duty to Diversify.
i. As part of determining the trust’s investment strategy and diversifying the trust, the trustee should periodically review the trust’s assets in light of the various circumstances and purposes of the trust.
ii. In general, trustees are obligated to diversify the trust investments unless such a diversification would be deemed imprudent. CA Probate Code § 16048.
iii. This means that the trustee must invest trust funds in various assets and classes of assets.
iv. Diversification also serves to manage the trust (and therefore the trustee’s) risk.
v. Factors to consider in how to diversify trust assets include:
1. Market conditions.
2. Tax planning.
3. Asset volatility.
4. Asset classes.
5. Term and purpose of the trust.
b. Consider Beneficiary’s Needs and Trustor’s Intent.
i. Any instructions in the trust agreement trump the default duty to diversify. CA Probate Code § 16046(b).
ii. Beneficiary needs may also impact investment choices.
iii. For example, a marital trust (i.e., a QTIP Trust) may require income-producing property necessary to ensure such trust qualifies for the marital deduction. Or a family business wholly-owned by the trust means that valuable real estate should not be sold.
c. Duty to Dispose of Unproductive Assets.
i. Trust property must be made productive in furtherance of the trust purposes. CA Probate Code § 16007.
ii. Assets may be deemed productive if they produce current income or are appreciating in value.
iii. Query whether unimproved real estate or beneficiary-occupied real property should be sold to fulfill duty to make trust property productive of income. Oftentimes, trust documents provide particular exceptions for such assets.
iv. If the trust holds significant unproductive property, the trustee should consider making adjustments between the principal and income accounts to reflect the lack of income. CA Probate Code § 16336.