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Submitted by: Joe Swanson
Joe Swanson is a member of a team that specializes in 401k, pension and IRA planning, and retirement income planning. The team includes CFA, CPA, MBA, CFP and CRPS designations.
The prospect of permanent federal estate tax repeal is quickly becoming an exercise in
wishful thinking. Consequently, us advisors are dusting off the proverbial estate planning shelf to resurrect a number of wealth transfer techniques. A combination of high real estate prices accompanied by a sober realization the federal estate tax may be permanent, has led to a strong resurgence of interest in Qualified Personal Residence Trusts (QPRT’s). This sheds light on this highly valuable estate planning strategy.
Profiling a QPRT Client
The traditional QPRT candidate is a wealthy unmarried person seeking to use this trust as a “marital deduction substitute.” While this profile is still applicable, the QPRT technique may also be effective for married couples with an estate in excess of the couple’s combined unified credit equivalent[1]to reduce taxes upon the death of the second spouse. Even older clients in their 70’s and early 80’s may consider a QPRT a “no lose” proposition.
A common characteristic that potential QPRT candidates share is a desire to remove a highly appreciating personal residence from their estate during life while minimizing taxable gifts. They should have a reasonable expectation they will outlive the trust term to prevent the value of the residence from coming back into the gross estate. If death occurs before the end of the specified term, the property plus any appreciation will be included in the estate. But this is the exact same result as if the client had done nothing.
How is it Done?
A client meeting the correct profile transfers their principal residence or second home[2] into a QPRT for a set period of time, typically between 10 and 20 years. A taxable gift is made at the time of transfer determined by the value of the remainder interest calculated using actuarial tables. Put another way, the value of property is discounted by the fact it will not be available to the remainderperson for years.
The grantor, unlike other transfers with a retained interest, can continue to use the residence throughout the term of years established by the trust. Most importantly, at the end of the term, 100% of the post-gift appreciation in the property escapes estate, gift, and generation skipping transfer taxes. Like most grantor retained annuity trusts (GRAT’s), the full fair market value of the asset will be included in the grantors estate should death occur first. Any aspiration to shorten the term to avoid the risk of death must be balanced against the risk of an increased taxable gift.
It is often appropriate for the remainderperson to purchase life insurance on the life of the grantor to guard against the possibility of premature death. The tax-free proceeds provide the liquidity necessary to offset the estate tax inclusion in the event of early death. Although a term life insurance corresponding with the length of the QPRT would seem like an obvious choice, clients should carefully consider permanent insurance held within an ILIT to provide cash for other estate planning needs at death.
The QPRT by the Numbers….
An example of a QPRT in action may be helpful to gain real insight into the leverage this technique offers to advisors and their clients. Consider the case of Mrs. Robinson, an unmarried individual in the 45% gift tax bracket. Her intention is to transfer her $1,000,000 personal residence to her college age daughter and future son-in-law. She subsequently transfers her residence to the trust while the 7520[3] rate is 5% and reserves the right to live in the house for 10 years. Using the governmental tables, the present value of her right to live in the personal residence is $386,087 (factor of .386087).
Since the value of the residence placed in trust is $1,000,000 and the income interest retained by Mrs. Robinson is $386,087, the value of the future interest gift is $613,913. The annual exclusion may not be used because this is a future interest gift, but the entire taxable gift can be sheltered by her gift exemption amount. In addition, even if her lifetime exemption amount has been fully used, a gift tax rate of 45% would only produce a gift tax of $276,261. If the $1,000,000 property appreciates at an after tax rate of 7%, the property will be worth $1,967,151 at the end of the 10 year term.
If Mrs. Robinson survives the term, none of the trust assets will be in her estate. At a 45% estate tax rate, the savings would be approximately $271,305 (45% X $1,967,151)-613,913. Furthermore, keep in mind since the property passed through trust, probate costs are avoided and 100% of the appreciation escapes taxation.[4] Lastly, a written lease entered into at fair market value shortly after expiration of the term ensures Mrs. Robinson may continue to live in the residence while maintaining cordial relations with her family.
Built-In Flexibility
Any estate planning technique is accompanied by a certain level of client insecurity. One of the greatest concerns is the possibility of premature death especially among a married couple that fear losing use of the unlimited marital tax deduction. Most modern QPRTs have a flexible provision called a contingent reversionary interest built into the trust document. Should this provision be triggered by an early death, not only the value but the actual residence will revert back into the estate of the decedent. This allows the grantor to utilize the marital deduction by passing the residence to the surviving spouse, and thereby postpone the estate tax.
Furthermore, this flexible provision will cause the trust to be classified as a “grantor trust” which will allow the grantor to pay and deduct property taxes and mortgage interest on his tax return during the term of the trust. Although payment of these expenses is considered an obligation of the grantor, this is another way to “defund” the grantors estate making gifts to beneficiaries.
Conclusion
Recent political, legislative, and financial events has led to justifiable confusion among clients seeking effective estate planning. Unfortunately, inaction caused by a lack of perceived viable options may invite disaster. Astute advisors aware of techniques like the QPRT can set themselves apart by offering powerful solutions to seemingly insolvable problems.
[1] The unified credit equivalent is $2 million per person in 2007-2008 & $3.5 million in 2009.
[2] A residence the term holder uses for personal use during the year for a number of days which must exceed the greater of 14 days or 10% of the days during the year that the residence is rented at fair market value.
[3] The Section 7520 rate is a governmental interest rate published monthly that values life estates, remainder interests and estates for term of years. An increasing 7520 lowers the value of the taxable gift creating further estate planning flexibility in periods of increasing interest rates.
[4] Although a full step-up in basis for the property will not be available to the remainder person, he or she will receive a fractionalized share equal to the ratio of the remainder- value to the value of the entire property. For instance if the grantor retains a 39% interest, the remainderperson would therefore receive 61% of the basis.
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