A market drop often creates opportunities in Estate Planning. The ongoing decline in housing prices creates such an opportunity. Estate and gift taxes are imposed on the value of property. It follows that a decline in market value means property can be transferred at a lower cost.
Those who own estates worth more than $2 million potentially face estate taxes under current law. For many people in this group, their first or second homes are among the most valuable assets they own. Your estate planning must include efforts to reduce the cost of passing these assets to the next generation eliminates a significant amount of the family’s estate and gift taxes.
An estate owner doesn’t want to save taxes by arranging his or her demise during a period of low asset prices. Instead, advanced estate planning can be used to make gifts and remove assets from the estate. Gifts that would have triggered taxes, or higher taxes, a few year or two ago can be made now at a lower or no tax cost. Making the gifts of property now also removes future appreciation of the assets from the estate.
It is important to remember the benefit of removing future appreciation from the estate. While home prices generally are declining now, they won’t do so forever. A modest appreciation rate of 3% annually from the market bottom will result in a substantially higher value 10 years later. Removing that future appreciation from the estate today will save substantial tax dollars.
One tax-favored way to remove a home from the estate is through the qualified personal residence trust (QPRT).
In the QPRT, the homeowner transfers the house to a trust. Under the trust, the former owner retains the right to live in the home and treat it as his or her home for a period of years. After the period of years ends, the beneficiaries of the trust receive title to the property. The beneficiaries usually are the adult children of the owner.
There is a gift to the children when the trust is created. The gift is not the current value of the home but is the present value of what the home is estimated to be worth in 15 years. IRS tables are used to determine the present value, and the percentage of the current value that is a gift depends on the owner’s age, the term of the trust, and current interest rates. A $1 million home might be discounted to a gift of under $500,000 today.
The creation of the QPRT might not result in a cash outlay to pay the taxes. The annual gift tax exclusion and lifetime $1 million gift tax exemption can be used to avoid paying any gift taxes today. Using all or part of the lifetime gift tax exemption would reduce the estate tax exemption available to the estate by the same amount.
During the trust term the original owner has all the benefits and burdens of ownership. The home can be occupied and used as an owner would, and the owner is responsible for property taxes, utilities, insurance, and maintenance. If there still is a mortgage on the property, the owner is responsible for paying it. The owner also takes deductions for mortgage interest and real estate taxes he or she pays.
A trust needs a trustee. It is best to name an independent person as trustee of the QPRT to avoid problems with the IRS, but some tax advisors believe it is acceptable for the owner to serve as the trustee. There needs to be a successor trustee named if the owner serves as the first trustee.
When the trust term ends, the beneficiaries take ownership of the house. If the owner wants to continue living there, he or she has to pay fair market rent to the children. The rent would be taxable to the beneficiaries, after subtracting real estate rental expenses such as depreciation. There should be a written rental agreement and an effort made to document the fair rental value of the home. The beneficiaries have the legal right to either sell the home or evict the owner.
There are some potential disadvantages of the QPRT. If the owner does not outlive the trust term, the home is included in the estate as though there never had been a trust. There will be a credit against the estate tax for any gift taxes already paid. So, except for the fees of setting up the trust, nothing is lost.
In addition, the heirs are not able to increase the basis of the home to its fair market value. The home is received as a gift through the trust, not an inheritance through the estate. Therefore, they take the same tax basis the owner had. But when they sell the home they would owe only the long-term capital gains rate on the appreciation. Without the QPRT, the full value of the home potentially would be subject to the top estate tax rate of 45%.
Owners of large estates should view the current real estate decline as an opportunity to remove assets from their estates at temporarily depressed prices. The QPRT is a way to remove a residence from the estate at a low tax cost while continuing to live in it.