CAUTION: Reading
this article may provoke self-inflicted slaps to the head and utterances of
"Why didn't I do this five years ago?"
In 1999, Farhad
Aghdami, a trust lawyer in Richmond, Va., suggested to Jim and Yolonda Roberts
that they put their home in a Qualified Personal Residence Trust to shelter
it from looming estate taxes.
Piedmont Lodge,
the Robertses' white clapboard house with six portico columns sitting on 53
acres near Keswick, Va., was worth about $1.6 million back then. The trust
lets them give the property to their four children for about a third of what
it was valued at in 1999. The couple, now 75 years old, can live in the home
for the 10-year term of the trust. When the trust expires in three years,
the house belongs to the children.
Here's where
you slap yourself. The home is probably worth close to $4 million now. All
of that appreciation was removed from the Roberts estate. "We are very
happy with how it worked out," said Mr. Roberts, a retired Exxon executive.
"We love the house and wanted to keep it in the family."
You keep hearing
how your home is your primary financial asset. As home prices have climbed
sharply in most areas of the country, many older Americans are finding themselves
living in an asset worth $1 million or more. Some also own vacation homes
that have increased in value.
Add that real
estate to stocks, bonds, life insurance and other property and suddenly people
who thought they were just average folks could expect to have those assets
subject to estate taxes after they die. Congress has set the exemption from
estate tax at $2 million, but as Carrie C. Simchuk, a trust and estates lawyer
at Perkins & Coie in Seattle, said, "It doesn't take all that long
to get to $2 million."
That's what
makes the QPRT, pronounced "cue-pert" by the experts skilled in
setting up these tax-reducing vehicles, so attractive these days. During the
Clinton administration, Congress made noises about limiting the trusts, but
in recent years no legislator has crusaded for their abolition.
Certainly a
lot of people have put aside worrying about estate taxes. After all, Internal
Revenue Service statistics show that the federal estate tax was paid by only
1.17 percent of estates of those who died in 2002, the last year with published
figures. That could be because few people amass appreciable estates or because
so many who did accumulate wealth had hired excellent tax planners. Either
way you look at it, it might seem even more irrelevant because Congress has
raised the exemption to $3.5 million in 2009 and then removed the estate tax
entirely in 2010.
The rub, of
course, is that the tax relief expires in 2011, which would bring the tax
back and scale back the exemption to $1 million if Congress does not act.
What Congress will do about estate taxes over the next couple of years is
anyone's guess, but tax planners say it is foolhardy for anyone with $2 million
in assets to do nothing and hope for the best.
"The worst
thing you can do is let it paralyze you into inaction," said Jim Ellis,
a managing director and estate planner at J. P. Morgan Private Bank.
The QPRT works
best for those people who expect to live another decade or so. The longer
the term of the trust, the more beneficial the gift is to the children. A
$1 million home in a three-year trust saves about $147,000, according to calculations
by Mr. Aghdami, but one stretching 18 years saves almost $850,000.
Here's the big
catch: The QPRT helps you sidestep the taxman, but you have to outrun death
to get the benefit. If the parent dies before the trust expires, the children
have to pay the estate tax on what the value of the house was when the parent
died.
Consider the
QPRT a gamble, but a reasonable one. It has to be set up wisely by a tax lawyer
who consults actuarial tables after a frank talk with the client about his
or her health and family medical history. But should the heirs lose when a
parent dies early, said Mr. Aghdami, the tax lawyer with the firm of Williams
Mullen, "they are no worse than if the parent had not set up the trust."
QPRT make the
most sense when interest rates are high. The higher the interest rate, the
greater the discount, which, in turn, increases the tax savings. When a home
is put into the trust its value is not the current value of the house, but
what is called the "present value" of the future gift - a deep discount.
For instance, a $1 million home in a 12-year trust is valued at $370,460.
The same house in an 18-year trust would be valued as a gift at only $185,400.
(Don't worry. This is about the only complicated concept in setting up a QPRT,
and fortunately the "present value" is determined by Internal Revenue
Service formulas.)
The government
sets those values reasoning that the heirs are not getting the value of the
house right then. The money they would have received is worth less in the
future, hence the discount. (It's the same concept that makes the cash value
option of a lottery ticket's winnings less than the annual payout option.)
Of course, that
ignores the possibility that the house increases in value. The QPRT makes
a lot of sense, as the Robertses can happily attest, when real estate is expected
to appreciate. "Even if it appreciates modestly, you are ahead of the
game," Mr. Ellis said. In the event that prices drop, a house would have
to depreciate a lot - say by half - before the trust makes no economic sense.
That's unlikely to happen.
The ideal time
for a QPRT, tax planners said, is after one parent dies. The widow or widower
inherits the shared property at its stepped-up value, that is, not what the
couple paid for it back in their day, but what its current value is. Then
it is placed in the trust.
Getting the
step-up is advantageous because it removes one of the few pitfalls of the
QPRT. Normally with QPRT, the heirs get the property at the "cost basis,"
the price the parents paid for the property. Should the heirs sell it, they
may have considerable capital gains. But estate planners point out that because
the capital gains tax is only 15 percent and the estate tax is 46 percent,
the QPRT, even with a cost-basis property, is still a good deal.
If the parent
outlives the trust, the parent can continue to live in the house by paying
the children fair-market rent. Turning their progeny into their landlords
may be disconcerting for some parents. If they can foresee conflicts, maybe
it's time to start spending so the last check written bounces or, alternatively,
stick the greedy ingrates with the estate tax.
For everyone
else who has what might be described as a loving and trusting relationship
with their offspring, the rent-back feature is but one more tax benefit. "It's
all good. They are continuing to transfer wealth downstream," Ms. Simchuk
said.
Dick Kinyon,
senior counsel at Morrison & Foerster in San Francisco, suggests another
twist. After the QPRT expires, the house is owned by a grantor trust and rent
is paid to that trust, so there is no income tax for the children to pay on
the rent.
The QPRT is
most popular as a vehicle to protect a treasured family vacation home. Often,
no one in the family wants to sell it, so there is little concern about a
capital gains tax. Paying rent for a vacation home is less of an emotional
issue. "The fact that you rent it is a way to pass wealth onto the kids,"
Mr. Kinyon said.
A good estate
and trusts lawyer will be brimming with ways to make these simple trusts even
better by making them more complicated. If a parent wants to hedge against
dying before a trust expires, a lawyer can ladder the trusts by putting a
third of a home in a 3-year trust, a third in a 7-year trust, and the final
third in a 10-year trust.
Splitting the
home into several trusts has another virtue. Split ownership is deemed to
reduce the value of the property, sometimes by as much as 30 percent. "People
would have to have a certain tolerance for complexity," said Ms. Simchuk,
the Seattle lawyer.
But over all,
she said, "this is a no-brainer for estate planning; it's free money."
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