As the federal transfer tax exemption increased over the years (currently at $5.45 million in assets – that’s the amount you can transfer to heirs federal estate-tax free), many people felt that they did not need to pursue lifetime asset transfer strategies as aggressively as in years past, when the exemption was only $1 million, for instance. Many clients thought their estate would not be subject to estate taxes with the higher exemption amount, and they stopped wringing their hands over how to move assets to family members in the next generation for purposes of reducing the value of their estates.
While such a conclusion is logical at first blush, in the ever-changing tax law landscape it might be best to continue to set yourself up properly, since the tax laws can and do change, and not always to the benefit of the high net worth taxpayer. One fairly easy technique for transferring real estate down to the kids without using up a large amount of transfer tax exemption is the Qualified Personal Residence Trust (QPRT).
Here is how the QPRT works: an irrevocable trust is established and a home is transferred to the trust by the “grantors” (the person or persons making the gift). A great asset to do this with is a vacation home that the grantors would like to keep in the family. The grantors choose a period of years that they may continue to live in the home as if it is their own. At the end of this residency term, the home is either transferred outright to the beneficiaries or kept in trust for the beneficiaries. The benefit of this structure is that the valuation of the gift to the trust is less than the actual market value of the asset (i.e. the vacation home) that was gifted.
Because the grantors made a gift of an asset that the children could not actually possess until the end of the residency term, the gift is considered a gift of a “future interest” rather than a “present gift.” Gifts of future interests are less valuable than present gifts according to the IRS, and thus the grantors are able to use less of their transfer tax exemption in removing the vacation home from their estate. So how can this not be too good to be true? Well, in order to get this leverage benefit, the grantors must outlive the residency term that they chose when establishing the trust. If they do that, then the asset is removed from their estate.
Here is a sample calculation:
Value of residence transferred: $500,000
Age of grantor at beginning of trust: 65
Term of the trust: 12 years
Government rate for valuing remainder interest: 1.8% (April 2016 – rate changes monthly)
Value of remainder interest and taxable gift – $291,970
Value of retained interest by grantors – $208,030
So for a taxable gift of $291,970, the grantors have moved a $500,000 asset out of their estate. If the vacation home continues to appreciate outside of their estate during the term while they are living in it, the leverage increases and the QPRT planning technique becomes even more powerful.
Now, you might ask, what if the grantors still want to use the house after the term is up? The grantors must pay rent to the owners of the vacation home (either the trust or the children) if they use the property. The payment of rent shifts additional wealth down to the children without using any transfer tax exemption. In other words, it’s gift- and estate-tax free. If the grantors use the house without paying rent, it could be determined that the children are making a gift back to the parents or otherwise compromise the planning.
As the QPRT technique demonstrates, lifetime gifting is still a valuable tool thanks to leverage. Lifetime gifting can be even more impactful in states like Washington and Oregon, which have a lower estate tax exemption than the federal amount, yet don’t recognize lifetime gifts. A review of your overall estate and your objectives can help determine if you are a good candidate for lifetime gifting.
If you’d like to discuss this technique further, please speak with a Washington Trust Wealth Management relationship manager and/or your attorney or CPA for guidance.
As Vice President and Senior Wealth Advisor, Greg provides financial analysis to high net worth individuals. He is the author of several articles for various publications and nonprofit organizations on estate and financial planning subjects.