By: Randall A. Denha, J.D., LL.M.
Now that the real estate market is in full swing and confidence is back, many clients are concerned about removing assets from their estates so they are not subject to estate tax. We are still experiencing historically low interest rates and it is not uncommon for individuals to own more than one home. In fact, many people with more than one home seek to transfer their real estate to the next generation and look for the best ways in which to do so. The new $5 million gift-tax threshold (indexed for inflation each year and currently $5.34 million) set for each individual encourages outright gifting, but there are better ways in which to make such transfers.
Transferring real estate can be done by gift, sale or by way of a hybrid approach. For purposes of this article, our focus is on transferring residential real estate by way of a gift to a Qualified Personal Residence Trust (“QPRT”) or by way of a sale and leaseback of the real estate to a Defective Trust (“IDIT”).
Qualified Personal Residence Trust (QPRT)
A QPRT allows one to make greater use of their gift tax exemption. IRS regulations provide a ready road map to accomplish an effective transfer that can save significant future gift and/or estate taxes. It is ideal for anyone who has a substantial estate and is expected to face future transfer taxes. For the purpose of a QPRT, a home can be either a primary residence or a second home (i.e. beach house, lake house, mountain house).
A QPRT is a lifetime transfer of a personal residence (primary or second home) in exchange for continued rent-free use of the residence for the trust term. Assuming that the grantor survives the trust term, the residence either passes outright to the beneficiaries of the trust or can remain in trust for their benefit. Essentially, a successful QPRT allows one to reduce the gift or estate tax cost of transferring a residence by leveraging the $5.34 million (2014 limit) gift tax exemption. The transfer of the residence to the QPRT is a gift for tax purposes. However, the tax will be considerably smaller than the estate tax consequences had no QPRT been created. Provided the donor has not already fully utilized the applicable credit against estate and gift tax, no tax may be payable at the time the QPRT is created. Since the donor retains the right to occupy the residence until the end of the QPRT term, at the time the QPRT is created the only gift made by the donor is a gift to the remainder beneficiaries of the future right to the residence at the end of the QPRT term. This deferral reduces the value of the gift considerably depending on the duration of the QPRT term selected and prevailing interest rates. In addition, all appreciation in the residence’s value after the transfer to the QPRT will escape estate and gift tax.
For example, a $1 million residence transferred to a QPRT by a 60 year old, retaining the right to use the residence for a fifteen-year term, will result in a $531,000 gift. Provided the donor survives the fifteen-years, the residence will not be included in his estate, nor will any of the appreciation in value of the residence occurring after the initial transfer.
A QPRT is an effective estate freeze technique and is most applicable to taxpayers with estates that would exceed the applicable exclusion ($5.34 million in 2014). It is a tax-efficient means of intra-family home transfer. During the QPRT term, the grantor can continue to utilize the residence on a rent-free basis. Because it is specifically allowed under tax regulations, there is little tax risk. Using a QPRT is a sort of wager or bet. If the settlor dies before the trust has terminated, the residence will be included in his or her taxable estate, and estate tax will be paid on it, because the settlor retained the use of the property for a period that did not end before his or her death. That is, the purpose of the trust will have been defeated. However, if the settlor does not die during the trust term, however, the property will be distributed to the child(ren) without further transfer tax.
Assuming the grantor survives the trust term, the grantor may be permitted to lease the residence back from the beneficiaries (presumably family members). Lease payments are another means to benefit heirs without any further gift or estate tax consequences. So long as the grantor pays fair market value rent, there should not be any adverse estate tax consequences (i.e. the IRS arguing that the grantor retained the right to use the gifted assets by virtue of failing to pay fair market rent.)
A few other limitations worth noting concern the irrevocability of the QPRT as well as the income tax component. The effects of a carry-over income tax basis v. step up in basis must also be considered. This concerns the income tax liability to the remainder beneficiaries, such as the children, if they sell the residence either following the settlor’s death or following termination of the trust. If they inherit the residence then the value of the residence is “stepped up” to its fair market value as of the date of the parent’s death. On the other hand, if the QPRT “bet” succeeds, i.e., if the settlor outlives the trust term and the children take the remainder under the terms of the trust, their basis will be the same as the settlor’s (i.e. “carryover basis”.) If there is substantial market appreciation over the price the settlor paid, the increased capital gains tax may well offset the lower gift tax achieved by the QPRT.
Finally, since a QPRT is a “grantor” trust, during the term the donor remains entitled to any income tax attributes of the residence, such as real estate tax deductions and other income tax advantages associated with home ownership.
Sale and Leaseback to an IDIT
Another technique to remove a residence from the value of the estate involves a sale of the residence to a specially designed trust. This specially designed trust involves the creation of a “defective trust” which causes the income to be taxed to the grantor of the trust, or the person who creates the trust. Certain tax provisions are required to be included in this trust in order to achieve the tax defect so that the grantor is treated as the owner of the trust. While this particular trust is “defective” for income tax purposes, it is still “effective” for estate and GST tax purposes. The significance of the defective nature of the trust is so that any transactions entered into by and between the grantor and the trust will be income tax neutral, yet still completely removed from the estate of the grantor.
The IDIT transaction with a corresponding leaseback is a powerful transaction. It offers taxpayers a powerful triple play: an estate-freeze and wealth-transfer technique, as well as an estate planning opportunity. If the assets which are sold to the trust produce a total return in excess of the interest rate charged on the note then wealth has been removed from the grantor’s estate, both gift and estate tax free.
Here is how the hybrid transaction of the residential real estate to an IDIT works:
1. Grantor creates an IDIT for the benefit of his/her descendants;
2. Grantor gifts or “seeds” an amount equal to 10% of the value of the residence to be sold to the trust. This gift will use up some of the gift tax exemption and be allocated GST exemption to protect the grandchildren (or other remote beneficiaries) from GST tax;
3. Grantor sells the residence to the trust for fair market value which is determined by an independent appraiser in return for a promissory note. The promissory note is generally structured as an interest only note with no down payment for anywhere between 9 years to more than 25 years;
4. The interest rate on the note is set at the applicable federal rate (AFR) which is the lowest rate permitted under tax law. The current AFR for the month of June for a 9 year note is only 1.91%.
5. The Grantor will now lease the property back from the trust which owns the property and will pay fair market value rent. The lease payments received by the trust are then used by the Trustee to satisfy the note payments due to the grantor. Recall that this back and forth shift in moneys between the trust and the grantor are all income tax free due to the “defective” nature of the trust.
6. The Grantor’s continued lease payments for use of the real estate serve to further reduce the value of his/her estate for estate tax purposes and serve as additional tax free gifts to the trust beneficiaries.
The decision to make a gift to a QPRT or enter into a gift/sale to an IDIT depends on a number of factors-age of the grantor, health of the grantor, the current AFR rate and 7520 rate, basis in the assets, valuation of the asset and whether GST planning is sought. Because of the still low interest rates we are currently experiencing, the technique that is likely to result in a better outcome for a family interested in transferring their real estate is the IDIT technique. However, it’s ultimately up to the clients and what his/her objectives are in deciding which approach is best.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.