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08 Apr

How You Own Your Home Can Save You Taxes

In Home by admin / April 8, 2013 / 0 Comments

Estate Planner Nov-Dec 1998
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Last year Congress changed the rules for taxing the gain resulting from the sale of a principal residence. These new tax rules may have a significant effect on the way you structure the ownership of your family residence for estate planning purposes.

The Changes

Under the Taxpayer Relief Act of 1997, eligible married taxpayers filing jointly may now exclude up to $500,000 ($250,000 for a single taxpayer or a married taxpayer filing separately) of such gain. This exclusion is available once every two years and replaces:

  • The one-time $125,000 exclusion from capital gain for a homeowner age 55 or older; and
  • The tax free rollover available to any homeowner who acquired a more expensive replacement home within two years of the sale of a principal residence. 

Step-Up in Basis

If you do not expect the appreciation in your family home to exceed $250,000, you will no longer need to put ownership in the name of the spouse who is most likely to die first. Why? Because you no longer need the step-up in basis available at death for assets included in the deceased’s gross estate to avoid capital gains tax when the home is sold.

If the appreciation in the family home will approach $500,000, consider joint ownership with your spouse, either through joint tenancy, community property (if available), tenancy by the entirety or tenancy in common. In such instances, one half the value of the residence will be included in the estate of the first spouse to die. It will receive a step up in basis, and the surviving spouse will have a $250,000 exclusion from gain on his or her one half interest in the residence. Therefore, you will eliminate or minimize capital gain on the sale.

Sale of Second Residence

The exclusion from capital gain only applies to the sale of a residence that has been your principal residence for at least two years. Accordingly, if you are considering selling your vacation home and it has appreciated substantially, deferring the sale for two years and taking steps to make the vacation home your principal residence may be tax advantageous.

Changing your principal residence is not necessarily easy or wise, however. Depending on a number of circumstances, you may need to completely change your domicile to a new state. Or you may need only to spend more time in the second home than in the first home for two years to make the vacation home your principal residence.

You may have intentionally changed your state of domicile to take advantage of favorable income tax treatment (Florida and Nevada, among others, have no state income tax) or to escape state imposed gift, inheritance or generation-skipping transfer taxes, but maintain a residence in your former state as well. Neither residence is considered a vacation home, but make an effort to show that the residence in the new domicile is the principal residence. When it comes time to sell the residence in the former state, however, you will owe capital gains tax on the appreciation.

The capital gain exclusions under the new tax law will not apply if you are not selling a principal residence. You may want to consider “moving” back to the old domicile for two years prior to a sale to re-establish that home as your principal residence. The benefit could be a savings of up to $100,000 ($500,000 gain exclusion times 20% tax rate). A disadvantage is that for two years you might be exposing yourself to the tax system you sought to escape. After the sale and tax savings, you can reestablish residency in the tax advantaged state. Keep in mind that after two years in the new principal residence, the exclusion from capital gain is again available.

The inconvenience and cost involved in changing a secondary residence to a principal residence may override the potential capital gains tax savings. Yet, if you are likely to sell or dispose of a residence in the near future, it may be worthwhile to consider the ramifications of a change.

Qualified Personal Residence Trusts

A gift of a remainder interest (effective after a term of years) in a vacation residence is a popular technique to leverage a gift to children for estate planning purposes. This type of gift uses a qualified personal residence trust (QPRT) or a residential grantor retained income trust (ResGRIT). You place the residence in trust and reserve the right to occupy it for a set period. At the end of the term, the residence is owned by the remainder beneficiaries (such as your children or a trust for their benefit) and you either become a rent-paying tenant or vacate the property.

One QPRT disadvantage is that the remainder beneficiaries inherit your basis in the property and will pay a capital gains tax on its subsequent sale. But if, prior to the sale, ownership of the residence vests in one (or more) of your children who is able to maintain the property for two years as a principal residence, then up to $100,000 in capital gains tax savings may be realized.

08 Apr

Use a QTIP Trust To Save Estate Taxes on Your Home

In Home,Marital Deduction by admin / April 8, 2013 / 0 Comments


Estate Planner Sept-Oct 1997
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Because the marital residence often is one of the most valuable assets held between spouses, planning to reduce the impact of estate taxes on its transfer is critical for most couples. Many couples, however, are missing out on tax-savings opportunities, such as using qualified terminable interest property (QTIP) trusts to gain discounts and reduce estate taxes.

Case 1: Missed Opportunities

George and Martha owned a $1 million home. Because they held the property in joint tenancy, when George died, it was automatically transferred to Martha by operation of law. The transfer qualified for the unlimited marital deduction, so it didn’t trigger any estate tax.

However, when Martha died, the entire $1 million value of the property was includable in her estate, which triggered considerable estate tax. Although Martha’s $600,000 exemption equivalent was available, her estate was still left with an estate tax on $400,000, which, assuming an effective tax rate of just under 39% and no other assets, would equal $153,000.

George and Martha could have avoided this result if they had split their joint tenancy and used a QTIP trust to take advantage of minority discounts, like John and Abby in the following example.

Case 2: Maximum Tax Savings

John and Abby, who also owned a $1 million home, took advantage of the simple estate planning technique mentioned above and reaped significant tax saving. How? They took title to the marital residence as tenants in common, with John owning a 50% interest and Abby owning a 50% interest. (If, instead, John and Abby held the residence as community property and not also as joint tenancy property, each spouse would hold a 50% interest, which upon death, he or she could pass to anyone.)

Upon Abby’s death, Abby’s interest in the residence passed to a QTIP trust established under her estate plan. John had the right to receive all the income from the QTIP trust during his lifetime, but Abby chose who would benefit after his death. The transfer of Abby’s 50% interest in the residence into the QTIP trust qualified for the unlimited marital deduction, so no estate tax was owed.

When John died, his 50% interest in the residence plus the value of the interest held in the QTIP trust were includable in his estate. On John’s estate tax return, John’s executor took the position that John’s $500,000 (assuming there was no appreciation on the residence since Abby’s death), 50% interest in the residence could be discounted by 30% because John owned only an undivided fractional interest. The 50% held in the QTIP trust could likewise be discounted. This meant that estate tax would be due on only $700,000 (John’s discounted fractional interest of $350,000 + the discounted QTIP trust interest of $350,000).

Because John’s lifetime exemption equivalent was still available, estate tax was owed on only $100,000, which, assuming a 37% effective tax rate, would equal $37,000, leaving $116,000 more for John’s and Abby’s heirs than was available for George’s and Martha’s heirs. Even if John had owned 60% on his death (with the QTIP holding 40%), a discount might have been considered because the interest still would have been an undivided fractional interest and not readily marketable.

Weighing the Pros and Cons

When valuing property for estate tax purposes, the whole is often greater than the sum of its parts. Because fractional interests in property are not readily marketable, it is generally accepted that they can only be sold at a discount. However, as discussed at left, the approach outlined here may continue to be challenged by the IRS. If you are severing a tenancy by the entirety, this may result in some loss of protection from creditors. Carefully weigh the benefit of intentionally splitting joint tenancies to take advantage of valuation discounts against the possibility of a battle with the IRS. o

Risky Business?

The Internal Revenue Service (IRS) could claim that the interest owned by John and the interest held in the QTIP trust were merged, and deem that John owned the entire interest in the residence at the time of his death. This argument, however, has been rejected by various courts.

One theory for rejecting the argument is that the deceased spouse could determine who the ultimate beneficiaries of the QTIP trust would be, leaving the surviving spouse no control over the disposition of the QTIP trust assets. So, in John and Abby’s case, while the QTIP trust assets would be includable in John’s estate for estate tax purposes, this inclusion would not create a merger of interests.

08 Apr

Donating Your Home to Charity

In Charitable Gifts,Home by admin / April 8, 2013 / 0 Comments

Estate Planner May-Jun 1998
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Case Study of a Tax-Smart Strategy

Sam is a widower, age 68, in good health and has an estate of $2 million consisting of a $900,000 Individual Retirement Account (IRA), $800,000 securities and cash portfolio, and a $300,000 home. Sam wants to leave his estate primarily to his children but also wants to make a substantial gift or bequest to his favorite charity. Sam is looking for a way to do this simply while being tax smart.

Since Sam is counting on his IRA and securities for income and flexibility, and wishes to continue to live in his home, an outright gift to charity is not an appealing option at this time. The solution Sam is considering is gifting a remainder interest in his home to his favorite charity.

How It Works

Income tax rules contain a specific exception that will allow Sam to both make a gift to charity of his home that won’t take effect until his death and receive a current income tax deduction for the present value of the remainder interest.

The Benefits

The present gift of a remainder interest in Sam’s home will result in three tax benefits:

1. Based on the current value of the residence and Sam’s age, Sam will be able to receive a charitable income tax deduction of $126,897, using the Internal Revenue Service (IRS) discount rate for the month of the transaction (7520 rate). Sam will need to get a qualified appraisal of his home since the charitable deduction will exceed $5,000. Also, in making the calculation of the present value of the remainder interest, Sam may choose the 7520 rate for the month in which he makes the gift, or for either of the two preceding months. The remainder interest will be valued higher and the charitable deduction will be larger if a lower 7520 rate is used.

2. Sam’s gift of the remainder interest in his home will also qualify for a gift tax charitable deduction, so he will not have to pay a gift tax on the transfer.

3. Title to Sam’s home will pass to charity upon his death, and his heirs will not owe estate tax on it.

A Flexible Option

This planning technique can be flexible to meet Sam’s specific needs. For example, if Sam determined that the gift of the entire value of the home was too large, he could leave the charity a fractional portion of the remainder interest.

Another alternative is for Sam to give the right to use the personal residence after his death to someone else before the charity receives it. However, this would significantly decrease the value of the remainder interest, and could cause gift tax. The person receiving the right to live in the house (a second life estate) after Sam’s death would be receiving a gift of a future interest and the gift would not qualify for the $10,000 annual exclusion. If Sam remarried and made the gift to his wife, it would not qualify for the gift tax marital deduction because her interest would not start until Sam’s death.
Generally this gift trap can be avoided if Sam retains the right to revoke the second life estate during his lifetime. This would remove the gift tax issue and would put the property in Sam’s estate for estate tax purposes. Accordingly, the second life estate would then qualify Sam’s wife for the estate tax marital deduction.

A mortgage on the residence at the time of the gift may make the well-intentioned gift more complicated. The contribution of the mortgaged property would be considered a bargain sale, with the donor “receiving” an amount equal to the outstanding debt on the property. The result is gain to the donor.

Additionally, the value of the income tax deduction is affected by the outstanding mortgage. If the existing term of the mortgage extends beyond Sam’s life expectancy, then the gift to charity is in theory subject to a liability. When Sam dies at his expected age, the remainder interest will pass to charity subject to the unpaid mortgage balance.

Accordingly, Sam’s income tax deduction probably should be reduced by the amount of the present value of that liability. On the other hand, if the remaining term of the mortgage is less than Sam’s life expectancy, Sam can agree to hold the charity harmless from the mortgage liability so the value of the remainder interest will not be affected.

Smart Choices

Making gifts to charity during your lifetime almost always offers more tax benefits than transfers occurring after death. However, many people do not want to jeopardize their present financial security by donating liquid assets to charity. Giving a remainder interest in a personal residence could be the answer for people who wish to accomplish both charitable and income tax objectives.

Home Improvement

Presumably, Sam will take care of all expenses related to the residence including repairs, maintenance, improvements, taxes, special assessments and utilities during his lifetime. If a successor life estate is being given to someone, then Sam’s estate plan should make arrangements for the payment of these costs.

Anything Goes

The special income tax exception that applies to Sam’s situation only requires that the remainder interest be in a personal residence. It does not have to be Sam’s primary residence and accordingly, if Sam had a vacation home, the remainder interest in that property could be used for the gift to charity. Of course, the definition of home also includes a condominium as well as a cooperative apartment. In fact, under the right circumstances, a house boat or a yacht would qualify as a personal residence.