Depressed real estate values pose obstacles for clients who are trying to sell a primary residence or vacation home. But for those who are concerned about estate taxes, the down market might turn out to be an opportunity.
By shifting a costly home-whether it is a prized mansion, pricey condo or cozy beachfront villa-to children who are likely to inherit it anyway, parents can remove both the asset and any subsequent increase in value from their estate. This could be an especially smart move if the property value has declined and is likely to recover.
In contrast to other sophisticated estate planning strategies, passing along a home makes sense even for people who are only moderately wealthy, says Lawrence P. Katzenstein, a lawyer with Thompson Coburn in St. Louis. For example, a widow with a co-op apartment worth $2 million and marketable securities totaling $5 million might not want to give away investment assets just to leave less for Uncle Sam--she needs to live on the income. On the other hand, by transferring her apartment (assuming the co-op rules allow it) she can reap a substantial estate tax savings without disturbing her portfolio.
Still, it's important to weigh these potential savings against a key income tax benefit the children would lose, says Barry C. Picker, a CPA with Picker & Auerbach in Brooklyn, N.Y. If the house has appreciated since the parents bought it and the children plan to sell it right away, they would have to pay capital gains tax: Their basis in the property equals what the parent originally paid for the home plus the cost of subsequent improvements. On the other hand, if property passed through the estate, they can adjust the basis in the property to the date of death value, reducing the tax they would have to pay on the sale.
Another issue to explore is whether the client is comfortable having business relationships with family members. A parent who wants to keep living in the house must pay fair-market rent to the children or an entity (like a trust) that becomes the owner, and that alone might send clients running for the exit. But you can point out that it's a smart estate tax move, because the rent is a way of giving money to family without having to pay gift tax.
These are the gift-tax rules that clients need to understand: You are allowed to give up to $13,000 a year to each of as many people as you like. Spouses can combine this annual exclusion to give $26,000 jointly. On top of this, you can make total lifetime gifts of up to $5 million ($10 million for married couples) before any tax applies.
To pack the most into the legal limits and minimize any gift tax owed, clients will probably want to discount the value of any real estate given away. Which strategy works best will depend on their situation. Here are some options:
Give partial interests. You can make gifts of shares all at once (for example, by giving various people an interest in the same property) or over time (say, if there was only one recipient). Since the recipient can't act unilaterally and is yoked together with other interest holders, the value of what's transferred can be discounted by about 15%, lawyers say.
This approach can work well, for example, if spouses bought an inexpensive place for their son to live while he was in college, and he plans to stay on after graduation. Through a series of combined annual exclusion gifts worth $26,000, the two of them can gradually make him the owner of the property without having to pay gift tax.
Just remember that it will be necessary to get a professional appraisal at the time of the first transfer, with follow-up appraisals if the value of the property has changed when the client makes subsequent gifts.
Use a grantor trust. Clients who want to benefit various people can avoid squabbles by making gifts to a trust that will benefit all of them, and choosing a trustee to oversee the property management. This trust should be structured as a grantor trust, meaning that the person who sets it up retains certain rights or powers, says Michael D. Mulligan, a lawyer with Lewis, Rice & Fingersh in St. Louis. Why? A grantor trust is not treated as a separate taxable entity, so there's no income tax on the rent paid.
Within these parameters, you can help clients develop variations on the theme, Mulligan says. Here too, it's possible to discount the value of the gift by transferring partial interests. A parent who does not want to use the lifetime exemption or incur gift tax can, in lieu of a gift, sell partial interests in the property to the trust, take back a promissory note, and forgive the note as rent payments. And since the parent can be the trustee of a grantor trust, these entities appeal to clients who are reluctant to totally give up control (even though, to reap estate tax savings, they must give up ownership).
Create a qualified personal-residence trust. With this tool, known as a QPRT (pronounced "CUE-pert"), you put your primary residence or vacation home into an irrevocable trust, retaining the right to live there rent-free for a specified number of years. During that time, the trust, of which you could be trustee, owns the property. If you survive the preset period-a condition for this technique to work-ownership can then pass to the beneficiaries, usually children, or go into another trust, often called a dropdown trust, for the rest of your life (at which point you would need to start paying rent if you still want to live there).
The taxable gift with a QPRT reflects the value of the right to acquire the personal residence a certain number of years from when it is set up, discounted by the probability that the person setting up the trust will live that long. Figuring the discount involves a complex actuarial calculation based on the Section 7520 rate set each month by the Internal Revenue Service. The higher the rate and the longer the term, the bigger the discount and the more savings associated with the QPRT.
At the same time, even when interest rates are low, as they are now, QPRTs can work well for elderly people since the discount goes up as life expectancy gets shorter, says Katzenstein. For example, assume a 70-year-old put a $2 million home into a five-year QPRT in November, when the Section 7520 rate was 2%. The value of the gift in that case would be $1,563,620, says Katzenstein, who created the Tiger Tables Actuarial Software (www.tigertables.com) to do such computations. In contrast, if an 80-year-old entered into the same arrangement, the value of the gift would be $1,228,740.
Unlike other discounting techniques, the QPRT is covered by Internal Revenue Service regulations that offer precise instructions about how to comply with the law and leave little doubt that this device is on solid legal ground, says Natalie B. Choate, a Boston lawyer and author of The QPRT Manual: The Estate Planner's Guide to Qualified Personal Residence Trusts. This makes them appealing to clients who are skittish about cutting edge tax-saving devices.
Set up a legal entity. For family vacation homes that you expect to be shared, Wendy S. Goffe, a lawyer with Graham & Dunn in Seattle, favors putting the real estate into an entity such as a limited liability company. (For tax reasons, property should not be placed in a corporation.) Then you can gradually give away shares in the enterprise.
This, too, can achieve valuation discounts, but is preferable to a trust in various respects, Goffe says. Most notably, it provides for smoother transitions of ownership and management-something you ought to address in an operating agreement.
One of the most important issues to cover is the procedure for selling or transferring ownership interests if, for any reason, a family member wants out. Will transfer be limited to the client's descendants (which rules out ownership by people who marry into the family)?
In a buyout, how will the price be determined? (The possibilities range from having other family members pay the full share of the appraised value to imposing a discount and installment payment plan.) How many owners must agree before the entire property can be sold?
Lawyer and journalist Deborah L. Jacobs is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide, www.estateplanningsmarts.com.