Tapping that New Real Estate Wealth for Estate Planning

Managing the equity in appreciated homes and second homes has become a pleasant and unexpected challenge for many. Especially on the coasts, residential real estate values soared the last five years. Suddenly owners, especially long-time owners, have properties that are more valuable than they imagined. For many families, real estate wealth exceeds the value of retirement accounts and warrants revisiting the Estate Planning strategies .

This wealth brings estate planning problems and obstacles.

One problem is that the wealth is not cash. A family can be wealthy on paper but struggle to meet expenses. Or the family might have enough income to meet regular expenses but be concerned about the future, especially medical and long-term care expenses. In addition, valuable real estate uses cash. There are real estate taxes plus maintenance and repairs. Longtime owners can spend more on real estate taxes today than they used to spend on all the property’s expenses. If they continue to own the property, significant estate taxes could be incurred.

Too often, the owners believe the only estate planning solution is simply to sell the home. A sale frees up the wealth, but it also incurs capital gains taxes that reduce the wealth. Many home owners have gains that exceed the $500,000 tax-free amount for married couples or $250,000 amount for singles. Second homes do not qualify for the exemption on gains. A sale also takes the enjoyment and use of the home out of the family.

Perhaps most importantly, a sale means the family foregoes future appreciation in the property. While I do not expect much real estate to appreciate at the rates of recent years, most areas should see steady appreciation over the long term of a decade or more.

Fortunately, a straight sale of the real estate is not the only option. Here is a review of some estate planning strategies home owners can use to continue enjoying valuable real estate while making use of at least some of the home equity.

Loans are one option. Retired people generally avoid debt, though recent trends indicate fewer retirees than in the past shun debt. There are a couple of ways debt can be useful. One reason to consider a loan is that the appreciation in the home might exceed the interest paid on a loan, especially at today’s interest rates and when the loan balance is of only a portion of the home’s value. If you borrow 50% of the home’s value at 6% interest, the home has to appreciate only 3% annually to break even.

A homeowner can set up a line of credit. There are several advantages to the line of credit. Only the amount actually needed is borrowed and only when the need arises. That means no interest is charged until the line of credit actually is tapped. When money is borrowed, generally only interest payments are required. Paying the principal can be deferred. The length of the deferral varies from lender to lender.

A reverse mortgage is another type of loan we’ve discussed in past visits, most recently in July 2004. The articles are available in the members’ section of the web site at www.RetirementWatch.com in the Cash Watch section of the Archive.

Reverse mortgages have some flexibility. You can receive a lump sum, monthly annuity, or other stream of payments. You can borrow the amount you anticipate needing during retirement to supplement other sources of income. No payments are due until the borrowers pass away or the home is sold.

The down side of reverse mortgages is that they are expensive. Interest and other fees can be quite high. For example, an $800,000 reverse mortgage today would require a payment of about $3 million in 24 years. That’s why I recommend reverse mortgages primarily for people in their late 70s or older and after other options have been considered.

A private annuity is another good option.

In a private annuity, the parents sell the property to their children. The children promise to make a series of payments to the parents for life. The amount of the payments is determined by IRS tables based on the property’s current value, current interest rates, and the parents’ ages. The obligation to make payments ends when the parents pass away. The private annuity gives the parents cash flow and transfers the property to the children. In addition, the parents recognize capital gains on the sale only as the payments are received.

The children have several options for making payments. Perhaps collectively they can afford to make the payments. Or, if it is a second home or the parents move, perhaps renting the home can help make the payments.

Another option is for the children to sell the home. Because the children just purchased the house, they won’t owe capital gains taxes. The entire sale proceeds can be invested, perhaps in a trust, and used to make payments to the parents for their lives. This does not keep the home in the family. But it does get cash to the parents and keeps all or most of the value of the property in the family instead of only the after-tax value.

Charitable gifts can generate more after-tax wealth for the family, though they eventually will deprive the family of the home and its future appreciation.

The parents can remain in the home by giving a remainder interest to a charity. The parents retain the right to live in the home for life. The charity receives title to the property after the parents pass away.

The benefit to the parents is that they get a charitable contribution deduction for the value of the charitable remainder interest. The deduction is determined using tables in IRS regulations and is based on the value of the property, the parents’ ages, and current interest rates. The older the parents are, the greater the percentage of the home’s value that is deductible. The deduction reduces the parents’ income taxes until it is exhausted, and that generates extra cash for the parents.

A charitable remainder trust is worth considering as an estate planning option. The parents create the trust and give the property to it. The trust sells the property, and no capital gains taxes are due because it is a charitable trust. The full sale proceeds are invested. The parents receive income for life, and they have some flexibility in setting the formula for the income payments and whether they are fixed or will increase with the value of the trust’s portfolio.

The parents also get a tax deduction for the value of the charity’s remainder interest when the trust is created. After the parents pass away, the charity gets the value of the trust.

So there are three tax benefits: there are no capital gains taxes on the appreciation in the property; the parents get a tax deduction for making the gift; and there are no estate taxes on the property. In addition, the parents get income from the trust.

Next month, we’ll review other estate planning strategies families can use to manage highly appreciated real estate and homes.