Estate Planner Sept-Oct 1997
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
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.