Estate Planning for your Family Home or Vacation Home

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Estate Planning, Probate, and Trust Administration

Estate Planning for your Family Home or Vacation Home in a Depressed Real Estate Market

By Greg Cobucci

An individual or married couple’s family home is usually one of their largest assets. Removing the present day value of the home from the estate can often result in huge estate tax savings because of the future appreciation of the home. Recently, changes in the tax law increased the estate and gift tax exemption to $5 million for tax years 2011 and 2012. While it is unclear whether the exemption will remain at $5 million beyond 2012, it is wise to take advantage of the $5 million gift tax exemption now. One interesting estate planning opportunity is amplified by the increased exemption amount when coupled with the current depressed real estate market.

Qualified Personal Residence Trust

A technique used by estate planners to utilize the gift tax exemption in effectively removing the home from the estate is a Qualified Personal Residence Trust or QPRT. In a QPRT, the home owners transfer their personal residence or vacation home to an irrevocable trust for a number of years (the trust term) and continue to live in the home. At the end of the trust term, the residence will pass to the beneficiaries of the trust (often your children). If the home owner would like to remain living in the home or using the vacation home after the trust term, they must pay fair market rent to the beneficiary, who is now the owner of the home. The payment of rent further reduces the former home owner’s estate. In addition, significant estate and gift tax benefits may be realized by transferring the home into a QPRT because any future appreciation of the home should not be subject to gift or estate tax.

Generally, QPRTs are not considered effective in a low interest rate environment as we are currently experiencing. However, the interest rate used to value the various interests involved in a QPRT is on the rise and together with the increased exemption amount and the depressed real estate markets, the QPRT may be beneficial. Here is why:

First, why is a low interest rate unfavorable?

The transfer of the home to a QPRT is a taxable gift, however the value of the gift is not the fair market value of the home at the time of the transfer, but rather the value of the beneficiary’s future ownership interest of the home (called a remainder interest). To calculate the value of the gift, the present value of your right to live in the home is subtracted from the fair market value of the home at the time you establish the trust. A lower interest rate results in a higher gift value, which is undesirable because it exhausts the gift and estate tax exemption.

Home values in Orange County are said to be down 25 percent in the past five years. The combination of a depressed real estate market and an increased estate and gift tax exemption may allow you to remove your home from your estate with little gift tax liability. Thereafter, any potential future appreciation from a real estate market turn around would not be subject to estate tax.

Let’s see how this would play out in an example:

John and Mary Smith are a married couple and are 55 and 53, respectively. The Smiths have not previously used any of their gift tax exemption. The Smiths own a personal residence in Orange County which they purchased for $5 million in March 2006, when the interest rate was 5.4 percent. If they created a QPRT with a 10 year term, the taxable gift to their children would be $2,930,900. The gift tax exemption in 2006 was $1,000,000. Thus, the exemption sheltered $1,000,000 of the gift, however, $1,930,900 would have been subject to tax at a rate of 46 percent.

Fast forward to March 2011, the interest rate is 3 percent and Orange County home values are down 25 percent. The Smith’s home is now worth $3.5m. If they created the same QPRT with a 10 year term, the taxable gift to their children would be $2,583,070 and they would not pay gift tax because the gift tax exemption is now $5,000,000. Additionally, any future appreciation in the home will not be subject to the estate or gift tax because the home has been removed from the Smith’s estate.

While the illustration above demonstrates that a QPRT can be a powerful estate planning tool it has a few disadvantages. Upon the expiration of the QPRT term, if the former home owners would like to continue living in the home or use the vacation home, they must pay fair market rent to the beneficiaries to avoid unintended gifts. The most significant disadvantage of a QPRT is mortality risk. Meaning if you do not survive the trust term, the home’s full value will be included in your estate.

Remainder Purchase Marital Trust

If you are a married couple, a Remainder Purchase Marital Trust or RPM trust may be an alternative to a QPRT because it eliminates mortality risk and can offer greater flexibility than a QPRT.

An RPM trust works as follows:

The home owner transfers the home to the RPM trust and gives his or her spouse an income interest in the trust for life or a term of years (the income interest is the right to live in the home) and simultaneously sells the remainder interest (the right to own the home at the end of the trust term) in the RPM trust to another grantor trust for its fair market value. The “purchasing” grantor trust will be for the benefit of the beneficiaries (usually the children). The transfer to the RPM trust will be designed to qualify for the gift tax marital deduction and avoid being included in the spouse’s estate at his or her death. Thus, no gift or estate tax will be due at the time of the transfer or on death of the couple. However, the beneficiaries must pay fair market value for the remainder interest.

The most advantageous aspect of the RPM Trust is the ability to eliminate mortality risk. As discussed above, in a QPRT, if the original home owner passes away the value of the home will be brought back into the estate. Because there is no mortality risk in an RPM trust, the home owner can stretch the length of the trust term, which decreases the value of the beneficiary’s remainder interest and the purchase price paid. However, there is risk associated with the RPM trust because it is not a creature of the Internal Revenue Code or Treasury Regulations, as is a QPRT. Therefore, this technique should only be considered after careful consideration and discussion with a qualified advisor.

Although this article provides a general overview of certain issues that are involved in determining whether a QPRT or RPM trust is right for you, it only scratches the surface of various legal and tax issues to consider. We welcome the opportunity to address any of your questions. If you would like to discuss whether estate planning for your residence or vacation home is right for you please feel free to contact Gregory J. Cobucci at The Busch Firm, (949) 474-7368 Ext. 185, email: [email protected] or any of the professionals at The Busch Firm denoted below.