Your home is among the most valuable assets in your estate, perhaps the most valuable. That makes it a key part of your Estate Planning strategy. The home also is among the most difficult assets to incorporate into your estate planning. You always need a place to live, so the home cannot be given away as easily as securities or cash. Also, a house is not easy to divide into small portions that qualify for the annual gift tax exclusion.
Fortunately, there are several strategies you can use to reduce estate and gift taxes on a personal residence.
One popular estate planning solution is the qualified personal residence trust (QPRT).
Suppose Max Profits, age 65, has a $500,000 home he wants his children to inherit, but he wants to live out his years there. Max can create an irrevocable trust and transfer the home to the trust. Under the trust terms, Max can live in the home for 10 years (or whatever period he sets). After that, the home belongs to Max’s children.
Max can continue to use the home after the 10 years if he pays rent or the children allow him to use it as a gift. Or at that point Max could move to another home and leave the current home for his children to use or sell.
The advantage of the QPRT is that Max is giving the home away today, removing both its current value and its future appreciation from his estate. But he is not giving away the full value, because he is retaining the right to live in the home for 10 years. Max’s gift taxes will be based on less than 100% of the value of the home, earning him a discount on the estate and gift taxes. The exact discount Max gets on the gift taxes depends on the term of the trust and current interest rates.
The table in the next column compares the gift taxes that would be paid using the QPRT to the estate taxes that would be due if Max were to hold the home until his death and his estate were in the 50% tax bracket. Three different trust terms are compared. The table assumes that the lifetime estate and gift tax credit was used for other assets.
To get these benefits, Max has to survive past the term of the trust. If he doesn’t, the full value of the home is included in his estate. That would leave the estate no worse than if he had done nothing. To benefit from the QPRT, you need to set a trust term that you are likely to outlive. Otherwise, you should consider other options.
If the home has a mortgage, the outstanding balance is subtracted when computing gift taxes. If Max makes future mortgage payments, they are considered additional gifts as they are made. If the beneficiary or trust makes the mortgage payments, then Max is treated as selling the property and receiving the amount of the outstanding mortgage balance in return.
Since you are giving the home away, the trust and your children will get a tax basis in the home equal to your tax basis. That means when your children sell the property they will pay capital gains taxes on the appreciation that accrued since you bought the home.
A QPRT is especially attractive for a second home. There are a number of additional rules that I won’t go into here. You’ll need to work with an experienced estate planning lawyer. The IRS doesn’t like these trusts, and you have to meet all the technical requirements for the deal to work.
A more creative strategy is to sell the home to your children. One couple in an IRS ruling sold the home to their children and excluded all the gain from income using the $125,000 exclusion that then was available to homeowners age 55 or older. The children could either get a traditional mortgage from a lender or have the parents finance the sale through a private annuity. In a private annuity, the children promise to make regular payments to the parents based on the value of the home, prevailing interest rates, and age of the parents.
|Fair Market Value||$500,000||$500,000||$500,000|
|Gift Tax Payable||$121,584||$ 99,679||$ 87,077|
|Final Home Value||$579,637||$671,958||$778,694|
|Estate Tax If No Trust||$173,891||$335,979||$389,492|
After the sale, the couple continued to live in the home. Again they had options. One option was to pay rent to the children. The rent would give the children a tax shelter, since it could be offset by depreciating the home, and lets the parents give money to the children without worrying about gift taxes.
The second option was for the parents to live in the home tax free. The rental value of the home would be a gift from the children. As long as the rental value of the home didn’t exceed the annual gift tax exclusion, there would be no tax consequences. (IRS Letter Ruling 8502027)
The results of this strategy are that the home and its future appreciation are out of both parents’ estates tax free, and the parents can continue to live in the home.
Here’s another strategy if you want to remain in the home the rest of your life and you want to reduce estate taxes by getting the house out of your estate. It is appropriate if you don’t feel a need to leave the home to your children, because there are other assets for them.
The strategy is the charitable remainder interest. You change the deed so that you retain the right to live in the home for the rest of your life but a charity gets ownership automatically upon your death. The interest you give the charity is known as a “remainder interest.”
You get an income tax deduction the year you set up the charitable remainder interest. The deduction is based on your age, current interest rates, and the value of your home. The older you are, the greater the percentage of the home’s value you can deduct. If you sell the home after setting up the charitable remainder interest, the charity will get part of the sale proceeds, and you will get part.
Suppose Max Profits at age 60 determined his house was worth $300,000 and the land on which it sits was worth $100,000. He decides to give a remainder interest in the home and land to a charity, reserving to himself the right to live in the home for the rest of his life. After doing the complicated computations required by the IRS, Max’s estate planning advisor determines that the value of the charitable remainder interest is $165,622. That is Max’s current tax deduction, and all future appreciation of the home is out of his estate. The deduction will vary with fluctuations in interest rates.
None of these strategies is reversible, so be sure you have the arrangement with which you are comfortable. Also, be sure to use an experienced estate planning professional to layout the alternatives and do the paperwork.