“Ed” telephoned me the other day with a problem. “Craig” he said, “I have a bank coming after me for $200,000. Does my revocable trust offer me any protection?”

I was surprised to hear that Ed was in financial trouble. While everyone has suffered under the recent economic troubles, the last time I spoke to Ed he and his wife were on solid footing.

As it turns out, it wasn’t Ed who caused the bank problem. I learned that Ed’s son, “Bruce” purchased a home five years ago, when Bruce was employed. In order to help Bruce qualify for the mortgage, Ed cosigned the mortgage note.

You can guess what happened. Bruce lost his job. Bruce then fell behind with his mortgage payments. The home was foreclosed. Since the value of the home has decreased significantly, the bank’s subsequent sale of the home following the foreclosure was for an amount less than the outstanding balance of the mortgage. The bank then obtained a deficiency judgment against both Bruce and Ed.

Since Bruce has no assets, the bank is seeking recourse from Ed. The first I learn of this mess was Ed’s call to me asking whether his revocable trust somehow protects him against the bank. I advised Ed that his revocable trust assets are deemed to be his, and are not a protected asset. Since Ed can freely spend and consume his trust assets, they are not protected against creditors. Ed’s credit rating could also be adversely affected by these problems.

This issue points to a real problem that is unfortunately becoming more common. Before co-signing notes for your children or grandchildren, one should consider the worst case scenario, and whether that scenario could be financially devastating.

In addition to the monetary losses Ed may have incurred, there could be gift tax repercussions to the guarantee Ed signed. While an old Tax Court case held that an agreement to guarantee the payments of another’s debts does not constitute a completed gift for purposes of the gift tax rules, the IRS position has in the past been that when a person guarantees the payment of another’s debts, the guarantor transfers a valuable property interest, and therefore a completed gift has occurred.

A controversial 1991 Private Letter Ruling, for example, held that a guarantee is a completed gift, although no guidance was provided suggesting what the value of such a guarantee might be. The IRS cited a Supreme Court decision Dickman v. Comr., a 1984 case that held a parent’s agreement to guarantee payment of loans conferred a valuable economic benefit to the child; as without the guarantee, the child may not have obtained the loan or would have had to pay a higher interest rate.

This controversial ruling has since been withdrawn without IRS comment. However the IRS may maintain the position that if the child defaults on the loan and the parent repays amounts under the terms of the guarantee, additional gifts are made to the extent that the parent is not reimbursed by the child.

In Ed’s case this would constitute additional heartache. Not only may he be required to step in to cure the deficiency on the mortgage foreclosure, he may also lose some of his lifetime gift tax exemption.

The bottom line is that one should tread cautiously when cosigning or guaranteeing family obligations.

©2009 Craig R. Hersch .Learn more at www.sbshlaw.com