A Complete Guide to the Different Types of Real Estate Ownership and Related Risks and Rewards Associated with Each Type
Cushing & Dolan, P.C.
Attorneys at Law
375 Totten Pond Road, Suite 200
Waltham, MA 02451
Todd E. Lutsky, Esq. L.L.M
To help illustrate the many different types of real estate and the variety of forms of ownership that go along with them, we will use our hypothetical family of John and Mary Public. John and Mary are both age 65 and have three children, namely a son named Bob who is 25 years of age, a daughter named Barbara who is 30 years of age and another son named Bill who is 35 years of age, all of whom are married with children. In addition, John and Mary own their own home, a vacation home, which is rented more often than it is used as a vacation home, three two-family rental properties and some investment accounts.
John and Mary’s entire estate is worth approximately $3,000,000 and all of their property is currently owned jointly. A friend of theirs, who is also in the rental business, was recently sued, which forced them to begin rethinking how they own their real estate from both a creditor and estate tax planning standpoint.
The balance of this article will explore the different forms of real estate ownership that are available to John and Mary for each type of property along with the probate, creditor and tax implications associated with each type of ownership.
THE PRIMARY RESIDENCE
Let’s begin with their home, which is currently owned as joint tenants by the entirety. It is important to note that this form of ownership can only be used between spouses and only with regard to their primary residence. From a creditor standpoint, this form of ownership is beneficial in that the creditor cannot force half of the property to be sold in order to satisfy the outstanding obligation against either spouse individually. Say, for example, that John was sued personally with regard to his business, which had nothing to do with Mary, the creditor would not be able to force Mary to sell the home in order to access John’s half of the equity. Another type of creditor would be the nursing home and this will be explored below.
With regard to protecting the primary residents from the nursing home, a spouse must be living in the home. This arrangement will make the home neither countable nor can a lien be placed on it. It is very important not to leave the home in joint names after one spouse is institutionalized as this will put the home at risk in the event the healthy spouse dies prior to the sick spouse. Finally, it is important to plan to protect the home after the sick spouse has been approved for Medicaid as the home will remain at risk if the healthy spouse were to need nursing home care in the future. Consider the use of an irrevocable trust to protect the home, which are explored below.
For single folks the home is considered non countable for Medicaid purposes as long as the applicant checks a box on the Medicaid application indicating that he or she intends to return home even if not likely to happen. However, the state will be able to place a lien on the property once they determine that there is no reasonable expectation that the applicant will return home. This means that the state will be able to pursue the property following your demise in an effort to recover some of the benefits that the applicant received during life. This is known as estate recovery. In other words, while the home may not be currently at risk for the nursing home it ultimately will be without proper advanced planning.
Planning Pointer: Always remember, once on Medicaid the rate paid to the nursing home is about half what would be paid privately; therefore, the lien will be much smaller than would otherwise be the case thereby increasing the chance of saving the home or at least some part of the sale proceeds for the family, as the case may be.
With regard to probate, this form of ownership would avoid those costs on the death of the first spouse as jointly owned property passes by operation of law and not through the probate process. However, in the event John dies first and Mary does no additional planning, then the home would be owned in her name 100% on her death and would therefore be subject to the probate process. This is a common mistake people make as many times the surviving spouse does not do any planning after the loss of a spouse, thus causing all of their previously jointly owned assets including bank and investment accounts to be subject to the probate process upon the death of the surviving spouse.
With regard to estate tax planning, this joint form of ownership would waste the first spouse’s exemption amount as all the jointly owned property, including bank and investment accounts, would pass under the unlimited marital deduction to the surviving spouse thus subjecting it to estate taxes upon the death of the surviving spouse. As mentioned above, the marital deduction allows a spouse to leave an unlimited amount of assets to the surviving spouse without every paying any estate taxes, but would effectively waste the spouses’ ability to utilize their current federal and state estate tax exemption amounts generally resulting in a larger estate tax due upon the death of the surviving spouse. There is however currently a portability rule in place for the federal exemption. Portability means that the federal exemption, which is currently set at $5,250,000 if not used by the deceased spouse, can be used by the surviving spouse. However, this should not be relied on for a whole host of reasons the biggest of which is that it is not automatic and instead a federal estate tax return will need to be filed and an election made even if a return is not otherwise required. In addition, if all the assets pass to the surviving spouse then they will all be subject to growth until the death of the surviving spouse. If instead you used the exemption and tucked some assets in trust for the surviving spouse all such assets up to the exemption amount can grow estate tax free from the date of death of the first spouse to the date of death of the surviving spouse. Finally, it is important to remember that this portability rule does not apply to the Massachusetts exemption amount, which remains at the $1,000,000 mark, which must be used on the first death or it will be wasted. A complete discussion of this portability rule is beyond the scope of this article but for more information on these estate tax rules and related portability issues please contact Todd E. Lutsky Esq. LL.M at 617-523-1555.
Therefore, the suggested form of ownership for John and Mary would be to have real estate owned in either revocable or irrevocable trusts. For estates worth less than $2,000,000 the assets can be owned in one joint revocable trust, but for estates larger than that the property should be transferred to a nominee realty trust with their respective family revocable trusts serving as 50% beneficial owners. For example, if John and Mary did not do any planning and left all of their assets jointly owned then on the surviving spouses death, while there would currently be no federal estate tax the Massachusetts estate tax would be approximately $182,000. However, dividing the assets equally between these trusts and sheltering the first million dollars of assets from estate taxes while holding them in trust for the benefit of the surviving spouse will result in a Massachusetts estate tax of only $99,600 for a savings of $82,400. If your estate is $2,000,000 or less then this type of basic planning would result in no estate tax due for a savings of $99,600 for the family. These revocable trust arrangements would allow them to remain in complete control of their home during their lives, avoid the costs associated with the probate process and ultimately help them utilize both their federal and state estate tax exemption equivalent amounts, thereby reducing and possibly eliminating their estate tax exposure.
If John and Mary were interested in protecting these assets from the nursing home they should consider the use of irrevocable trusts. The irrevocable trusts do all the same things as the revocable trusts mentioned above but add the nursing home protection component while still ensuring that they retain a significant degree of control over the trust assets. A complete discussion of revocable and irrevocable trusts and estate taxes are beyond the scope of this article, but to learn more about these topics you can call Todd E. Lutsky at 617 523 1555 for an initial consultation.
Finally, for single folks the revocable and irrevocable trusts offer the same benefits from nursing home protection to avoidance of probate and ensuring the proper distribution of your assets following your demise. The only thing that these trusts do not offer single folks is the ability to reduce their estate tax exposure. Remember these trusts are generally designed to double the estate tax exemptions for a married couple but if you are single you only have your own exemption to work with. This does not mean that you should not do estate planning but simply that more sophisticated planning such as the use of family limited partnerships and gifting trusts may be needed.
TO GIFT OR NOT TO GIFT THE PRIMARY RESIDENCE
John and Mary then considered giving their home to their children during their lives. Gifting the home or any highly appreciated piece of property to the children is not generally considered a recommended option in terms of real estate ownership, as it is fraught with problems. First, John and Mary would have lost complete control over any such real estate during their lives. With regard to their home, if they did not retain a life estate, they would have lost even the right to live there for the balance of their lives. Furthermore, if they gifted the entire property they would have lost the ability to sell any such property or use the proceeds, while strapping their children with negative capital gains tax consequences. Finally, this form of ownership would expose the asset to their children’s creditors such as divorces and financial difficulties while they are still alive which could certainly adversely affect John and Mary. A discussion of selling property with a reserved life estate is beyond the scope of this article.
In this regard, while the gift of any highly appreciated property may result in a gift tax to the giver, it does not result in any immediate tax consequences to the recipient, but the recipient would receive a carryover basis from the giver. In other words, if John and Mary’s entire cost basis for their home, including all capital improvements made over their lifetime is $100,000, then the children would receive that same cost basis thereby trapping any capital gain that is currently built into their residence. Just a reminder, this same capital gains tax problem exists when you gift highly appreciated stocks as well. Even though currently each person has the ability to gift up to $5,250,000 of assets gift tax free, it may not always be the best thing to do.
For example, assuming John and Mary gave their home to the children and upon their demise, the home was worth approximately $500,000, and the children decide to sell it, they would have to recognize a $400,000 capital gain on their individual income tax returns. Assuming the new 20% tax rate at the federal level, a 5% tax rate at the state level, plus the new 3.8% Obama tax and that would result in a tax liability of approximately $115,200. Remember, they may have similar capital gains built into their rental properties as well, so the amount of capital gains tax could be in the hundreds of thousands of dollars if they were to partake in a big life time gifting plan as a means of reducing their estate tax instead of an estate tax plan through the use of trusts described above.
Instead, John and Mary should own their home in their respective revocable trusts as mentioned above. These revocable trusts would allow them to sell their home at any time and avoid any related negative capital gains tax consequences while at the same time better utilizing their federal and state estate tax exemptions which allow them to each shelter currently up to $5,250,000 federally and $2,000,000 Massachusetts estate tax free. Furthermore, if they have owned and used their property as their primary residence for two of the last five years and then sold it, they would be entitled to avail themselves of a $500,000 capital gains tax exclusion, thereby virtually eliminating any capital gains tax consequences associated with the sale. Finally, owning their home in revocable grantor trusts will not jeopardize this capital gains tax exclusion.
Furthermore, by having the revocable trusts pass their home to their children following their demise, the children would receive what is known as a step-up in basis for capital gains tax purposes. This means that the children’s cost basis in the home or any other appreciated assets would be stepped-up to the fair market value as of the date of John and Mary’s demise, thereby eliminating any capital gains tax consequences to the children in the event they sold the home shortly after their demise. In other words, if the home had a fair market value of $500,000 on the date of John and Mary’s demise and the children sold it shortly thereafter, their basis would be $500,000 thereby eliminating any capital gain and saving the children approximately $115,200 in capital gains taxes.
Planning Pointer: By John and Mary using the trust approach to planning instead of gifting, assuming there were similar capital gains taxes built into their rental properties, which they would likely be higher due to depreciation over the years, the gifting approach would have resulted in capital gains taxes for the kids of approximately $460,800 ($115,200 x 4 properties). Instead by doing the basic planning through the trusts and keeping the properties until they died, thereby eliminating the capital gains tax through the step up in basis, the estate tax due would have only been $99,600 as shown above. This is an over all tax savings of $361,200. Please do not just gift your assets away simply because you can without paying any gift taxes as there may be larger problems down the road.
Finally, a large portion of these tax and control benefits can be obtained through the use of grantor irrevocable trusts which add the benefit of protecting these assets from the costs of long term care, which the revocable trust does not offer. Please contact an elder law attorney for more detailed information on the use and operation of these irrevocable Medicaid type trusts.
OWNERSHIP OF RENTAL AND/OR COMMERCIAL PROPERTIES
John and Mary must now consider the various forms of ownership for their rental and commercial properties. As mentioned above, they are unable to own these properties as joint tenants by the entirety as they are not their primary residence. John and Mary, like many married couples, currently own these properties as joint tenants with the right of survivorship. From a probate standpoint, this means that, upon the death of the first spouse to die, the property will automatically pass by operation of law to the surviving spouse outside of the probate process. Although avoiding probate is a benefit, unless the surviving spouse does some additional planning, upon the surviving spouse’s death all the real estate will be owned in her own name and therefore subject to the probate process.
Furthermore, joint tenancy offers no estate tax planning benefits, as all of the real estate would pass under the unlimited marital deduction to the surviving spouse, thereby unnecessarily inflating the value of the surviving spouse’s estate and correspondingly increasing the estate tax exposure. Always remember estate taxes are to be paid on the surviving spouse’s death and the less planning that is done during life, results in more taxes being due on the surviving spouse’s death.
From a creditor standpoint, in the event a tenant gets hurt on one of their rental properties, the lawsuit would be against both John and Mary individually thereby exposing all of their remaining rental and commercial properties, along with their personal residence and other assets to this particular creditor. Therefore, this form of ownership does not provide any creditor protection.
From a nursing home perspective, these are countable assets and will prevent the institutionalized individual from becoming eligible for Medicaid benefits. Typically the state will place a lien on these properties if owned in your own name and then force you to sell them and to use the proceeds to pay for your nursing home care. This is why advanced planning through the use of irrevocable trusts, mentioned above, is essential in order to save these family lake, cape and or rental properties.
Planning Pointer: Even if no advanced planning was done you can still try to rent out the vacation home. Of course the rental property is already rented out and as long as it is generating income essential to self support, the state will allow you to keep the property and deem it to be non countable for Medicaid eligibility purposes. However, the state will place a lien on the property in case it is sold during life and it will be there so the state can recover the benefits paid out following the death of the applicant. This is known as Estate Recovery. Remember, the rent will be used to offset the Medicaid benefits thereby reducing the lien. In addition, being on Medicaid is better than private paying since the Medicaid rate is around half the cost of private paying the nursing home which in turn helps to save these properties. This way at least the family will have a better chance at the death of the owner to either get a mortgage to pay off the state and keep the property as the lien amount will be much smaller than if they were not on Medicaid, or sell it and be able to keep more of the proceeds than would otherwise have been the case.
There are, however, no negative income tax consequences to this form of ownership for, if John and Mary were to sell any property, they would be subject to the normal capital gains tax rates, including ordinary income tax rates for recapture of the depreciation expense that was taken while the property was being rented. Therefore, John and Mary conclude that they should not own their commercial and/or rental real estate as joint tenants with the right of survivorship.
John and Mary then considered arranging the ownership of their rental and/or commercial real estate as tenants in common. This simply means that both John and Mary would have a one-half undivided interest in each such property. In this regard, upon the death of John, he would have the ability to direct how he leaves his one-half interest in the property, instead of it passing by operation of law to his surviving spouse, Mary. However, if John were to own his one-half interest in his own name, then, upon his demise, it would also pass through the probate process rather than avoiding probate as with the joint tenancy arrangements discussed above.
If, however, John and Mary’s revocable trusts owned these properties 50% each as tenants in common, then, upon the death of the first to die of either John or Mary, their half of the property would avoid the probate process as it would be owned by a trust instead of them personally. It would also ensure that the surviving spouse is able to benefit from the trust assets during his or her life. Furthermore, the revocable trusts would be designed in such a way as to not only insure the proper disposition and control of the assets following their demise, but also to insure that they each more fully utilize their current federal $5,250,000 and $1,000,000 Massachusetts exemption equivalent amounts, thereby reducing and possibly eliminating their estate tax exposure.
From a creditor protection standpoint, whether John and Mary own these properties as tenants in common in their own name or whether their respective revocable trusts each own a 50% interest as a tenant in common, either arrangement would provide no creditor protection during their lives. For example, in the event an individual gets hurt in a rental property and sues, the law suit would be against both John and Mary either individually or as trustees of their respective revocable trusts thereby exposing the balance of their real estate as well as their home and other personal assets, to this particular creditor. It is important to note that, although these revocable trusts provide significant benefits in terms of their ability to reduce the costs associated with the probate process as well as lower, and in some cases eliminate, estate taxes, they nevertheless provide no protection from general creditors.
Finally, these revocable trusts also do not provide any protection from the costs associated with nursing home care. If protecting your assets from the nursing home is important to you then you should explore the use of Medicaid irrevocable trusts. Briefly, these are trusts that will still enable you to avoid the costs associated with the probate process, utilize your estate tax exemption amounts so as to reduce and or eliminate your estate tax exposure, ensure the proper disposition of your assets following your demise but also protect your assets from the costs of nursing home care. You will also be able to keep a significant degree of control over these assets even though they are in an irrevocable trust. Be mindful that it will take five years from the date you set up and fund these irrevocable trusts to fully protect the assets in them. For a more detailed discussion on these irrevocable Medicaid trusts please contact Todd E. Lutsky Esq. LL.M of Cushing and Dolan at 617-523-1555.
OWNING RENTAL REAL ESTATE WITH CHILDREN OR OTHERS
Another common mistake that occurs when dealing with real estate ownership is owning it either with a child or a friend as tenants in common. Say, for example, John and Mary simply wanted to add all of their children’s names to one of their rental properties as a tenant in common. Now, John and Mary will have significantly reduced their control over that piece of property for, if they ever wanted to sell it, they would now need their children’s permission. In the event the children did agree to sell the real estate, John and Mary must remember that a portion of the proceeds would go to the children and not them. This may be a problem, especially if John and Mary needed that money to enhance their retirement, or buy a replacement property. In addition, even if the kids wanted to give back the proceeds they may be subject to a gift tax and would have to worry about the gift tax rules that were discussed above. This is all on top of any capital gains tax that would have been paid by kids from the sale of the property.
From a probate perspective, owning assets as tenants in common does not avoid the probate process upon the death of any owner. Also, the owner that dies is allowed to control where that asset goes at his death unlike jointly owned assets that at least pass directly to the surviving joint owner and outside of probate. This may be especially problematic if the child were to die before the parents and that child left the property to his or her spouse which of course may not have been what the parents would have wanted to happen to the property.
From a creditor standpoint, John and Mary have exposed this particular rental property to their children’s creditors. In other words, in the event any one of their children were to have a car accident, financial difficulty or a divorce while John and Mary are living, then that particular piece of property would be exposed to those creditors. John and Mary also consider the flip side of this equation, which is that, if a tenant gets hurt on the rental property and files a law suit, that such suit would still be against John and Mary individually, but would now include all of the children who’s names appear on that particular deed as well as exposing all of their homes and other personal assets to that creditor.
John and Mary also considered the income tax consequences of such an arrangement. In other words, once they add the children’s names to a rental property, they must also sacrifice a portion of the rent as such rent must be allocated among the owners equally. Their portion of the rent must be picked up on the child’s individual income tax return as the IRS does not like it if rent is being reported on someone’s return that may be in a lower bracket when it could be picked up on the child’s return who might be in a higher bracket than the parents. Finally, once John and Mary add either their children’s names or a friend’s name to a piece of property, whether it be as joint tenants or as tenants in common, there always remains the possibility that any individual owner can petition the court to partition the property and force a sale of the property. Finally, such an arrangement may result in a large gift tax obligation to John and Mary. Nothing good can generally come from gifting away appreciated real estate to your children.
OWNING RENTAL REAL ESTATE IN A DELAWARE SERIES LIMITED LIABILITY COMPANY AND OR A MASSACHUSETTS HOLDING COMPANY ARRANGEMENT.
After exploring the various forms of real estate ownership, John and Mary have decided that they would like to maintain complete control over their real estate, avoid the costs associated with the probate process, reduce and possibly eliminate their estate tax liability, protect their assets from creditors, avoid any negative income tax and/or gift tax consequences with their choice of ownership while, at the same time, insure the proper disposition and control of their assets following their demise.
One recommended approach to accomplish such a tall order would be the implementation of a Delaware Series Limited Liability Company. In this regard, John and Mary would establish a series limited liability company into which they would contribute their rental and commercial properties. Each property would be owned by a separate cell inside the single series limited liability company. It is important to note that their home cannot be transferred to this series limited liability company, as it does not have any business purpose associated with it. In addition, placing the home inside such a company would result in the loss of the capital gains exclusion associated with the sale of your primary residence. In exchange, they would each take back a 50% ownership interest in the company. However, to avoid probate and help with their estate tax concerns, they would each transfer their membership interests in the company to their respective revocable trusts while gifting 2% of the company to the kids in order to take advantage of an additional estate tax planning valuation discount. The balance of the shares would be owned inside their respective revocable trusts or irrevocable trusts mentioned above.
The series limited liability company provides that no corporate action may be taken without the majority of owners being in agreement. From an estate tax planning standpoint, since neither John nor Mary individually will have a controlling interest, estate planning attorneys are able to apply discounts in the overall range of 30% to 35% for lack of the marketability and lack of control associated with this type of ownership when valuing such assets for estate or gift tax purposes.
In the event John and Mary decide to gift a portion of their interest in the series limited liability company to their children during their lives, these same discounts would be applied as of the date of the gift. Prior to any such gifting a 9 to 1 non voting dividend would be issued so that the children would be receiving only nonvoting interests in the series limited liability company, that would enable John and Mary to gift approximately 30% to 35% more than would be allowable under the current $14,000 present interest exclusions mentioned above, as well as retain control over the company. The application of these discounts enables John and Mary to transfer even a larger portion of their assets either during life through gifting or at death. Finally, it is important to note that John and Mary do not have to make any gifts and these discounts would still be applied as of the date of their death provided the trusts that will own these shares are drafted correctly.
The immediate effect of this form of ownership will serve to reduce the value of that portion of John and Mary’s real estate investments transferred to the series limited liability company, and therefore reduce the overall value of their gross estate and correspondingly lower their estate tax exposure by the discounted amount. Finally, in the event they decide to gift a portion of their interest in the series limited liability company during their lives to their children, this technique would serve to freeze their gross estate as to the value of any assets so transferred because all such assets and their future appreciation will be outside of their gross estate.
Insofar as federal annual income taxes consequences are concerned, John and Mary would continue to pay all of the income taxes associated with the series limited liability company at their lower individual rates, just like they used to prior to establishing this company. In this regard, series limited liability companies are flow through entities and pay no tax but, in turn, will flow the series limited liability company=s income proportionately to its respective owners. The portion of the income that would flow to each of them as 50% owners will be picked up on their individual income tax return. In the event John and Mary were to transfer a portion of their ownership interest in the series limited liability company to their children, then that portion of the company’s income would also flow through to their children who would need to include it on their individual income tax returns. Therefore, there are no adverse income capital gains or gift tax consequences associated with this form of ownership.
From a creditor protection standpoint, for example, if the tenant in Rental Property #1 got hurt and filed a law suit, assuming Rental Property #1 is owned by Series #1, then the law suit would be filed specifically against the series limited liability company Series #1, rather than against John and Mary individually, thereby protecting their home and other personal assets from such a law suit. Furthermore, the creditor would be prohibited from pursuing the other rental or commercial real estate owned in the separate cells inside the single series limited liability company thereby further reducing John and Mary’s creditor exposure. Finally, prior to transferring any encumbered property to these series limited liability companies, it is important to obtain bank approval.
From an administrative standpoint, the series limited liability company requires that only one income tax return be prepared each year and only one filing fee be paid per year per state in which you operate. However, it is important to maintain each series as a separate entity by perhaps keeping separate books and records as well as separate bank accounts for each series. In addition, the estate planning attorney should prepare a separate series contract for each such series as well as separate stock certificates for each series.
For folks who would rather not go to Delaware, you can set up a holding company in Massachusetts and transfer all of the rental properties to it. John and Mary would take back a similar form of stock ownership as mentioned above. The holding company could then transfer each property to a separate sub LLC which would be wholly owned by the holding company. This would still provide the same creditor protection as the Delaware LLC and the same estate tax planning discounts. Finally, there would only be one tax return required for the holding company because the single sub LLCs do not have to file as they are disregarded entities for tax purposes. All of the income and expenses will flow through the holding company and be reported on John and Mary’s personal return. For a more complete discussion of these entities please contact Todd E. Lutsky Esq. LL.M of Cushing and Dolan at 617-523-1555.
OWNING RENTAL PROPERTY IN A REGULAR LIMITED LIABILITY COMPANY
John and Mary may have also considered owning their rental and/or commercial real estate in a regular limited liability company as opposed to the series limited liability company mentioned above. The biggest difference between a series limited liability company and a regular limited liability company is that the series limited liability company provides individualized protection for each such property owned inside the company. The regular limited liability company may be more appropriate for people who own a single rental property, but most certainly no more than two.
In other words, if, instead, John and Mary established a regular limited liability company as the owner of their rental and/or commercial real estate and that same tenant in Rental Property #1 got hurt and filed a law suit, the suit would be against the entire company and all of the other rental and/or commercial properties would also be exposed to that creditor. However, it is important to note that the regular limited liability company would provide protection against John and Mary’s home and other personal investments and bank accounts as the law suit would be against the company and not them personally. The series limited liability company would offer enhanced creditor protection as shown above.
John and Mary have concluded that by owning their real estate through a combination of revocable trusts and a series limited liability company that they will avoid a lot of the pit-falls associated with the more common forms of real estate ownership mentioned above. The revocable trusts will enable John and Mary to retain complete control over their assets during their lives, reduce the costs associated with the probate process, insure the proper disposition and control of their assets following their demise while, at the same time, enabling each of them to more fully utilize both their federal and state estate tax exemptions, thereby reducing, and possibly eliminating, their estate tax exposure. In addition, the series limited liability company enables John and Mary to retain control over their assets during their lives, accelerate their lifetime giving, provide an enhanced level of creditor protection as well as avail themselves to the estate and gift valuation discounts mentioned above, which will serve to further reduce their estate tax exposure. Through some basic estate planning techniques, John and Mary can truly have their cake and eat it too.
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