Leverage 2010 Strategies to Optimize Your Clients’ Estates in 2011 and Beyond
Posted on Wed, Sep 22, 2010 @ 03:12 PM
By: Roger McClure
Washington Wealth Counsellors (R) PC
Member of WealthCounsel
Make Gifts Before 2011. Unless Congress is able to agree on what the estate tax ought to be after the November election, the estate tax will automatically be reinstated January 1, 2011 with an exemption of only $1,000,000 and a maximum tax rate of 55%. This is because the Bush phase out of the estate tax expires by its own terms at the end of 2010. In 2010, there is no estate tax and this presents a last minute opportunity to reduce estate taxes. According to our informal, unscientific survey of advisors, most tax advisors are convinced that a reported gift in 2010 will not be deducted in the future from the $1,000,000 estate tax deduction after 2010; a minority of advisors believe the government will be able to subject gifts completed in 2010 to a future estate tax. If our majority is correct, a way to save on future estate taxes is to make gifts in 2010 because in 2010, gifts do not reduce the future $1,000,000 estate tax exemption, but the same gifts made only months later in January, 2011 will reduce the $1,000,000 estate tax exemption. Gifts made in 2010 greater than the $13,000 exemption per person do reduce each person’s $1,000,000 exemption from gift taxes. If you had a chance to get a 55% reduction, would you take advantage of this 55% discount?
Story of Sam and Sally. Sam is a retired government employee
and he and his wife Sally own their home in the wealthy Washington suburbs worth $1.5 million; they bought it years ago for $100,000. They paid off their mortgage. Sam invested in the stock market, has a retirement account from the federal government, life insurance and some rental property totaling about $1,000,000. Sarah also has her investments, retirement funds and savings which total $1,000,000, Sam and Sarah have set up revocable living trusts which will maximize use of each of their individual estate tax exemptions in 2011. If Sam and Sally die after 2010 when there is $1,000,000 per person exemption, their total combined estate tax exemptions would be $2,000,000. Because Sam and Sally’s taxable estate totals $3,500,000, less their combined exemptions of $2,000,000, they would pay estate taxes on $1,500,000 for a tax of about $750,000 in 2011.
Property Settlement Agreement. Sam and Sally change the title to their house so that each of them owns 50% of their residence as tenants in common. Sam and Sally enter into a property settlement agreement that is enforceable under their state law as a division of property in the event of divorce. This property settlement agreement specifically prohibits either of them going to court and asking the court to order a sale of the property. This is called an action for partition, which will be prohibited by their property settlement agreement.
Appraisal Provides 35% Discount. They retain an appraiser of the value of their 50% interests in the residence and the appraiser issues a well documented opinion that a 50% interest in the residence is worth not $750,000 (one half of the $1,500,000 market value), but is worth $500,000, a discount of about 35%. This is because a 50% interest is a divided interest and people are not willing to pay full price for a property in which they will only own 50%. Also, due to the prohibition of a partition action, if a person bought a 50% interest, the buyer could not get out of the investment until the other owner agreed to sell the property, which is a restriction on transfer. In the past, the combined discounts resulting from a restriction on transfer and a divided interest were as high as 50% on such arrangements.
Establish Qualified Personal Residence Trusts. Sam and Sally each then execute their own qualified personal residence trust (QPRT). A QPRT is allowed under IRS regulations and must comply with those regulations. The terms of the QPRT say that each will own and have the right to reside in the property during a certain number of years and after that time period, they no longer own the property. After the selected time period, their children will own the property through the trust. Each of Sam and Sally select a different time period that is less than their individual life expectancy. They then transfer their interests to their QPRTs and the QPRTs are also bound by their property settlement agreement which prohibits a partition action. After the time period in the QPRT, they rent the residence from their children or move to a retirement community, based upon what Sam and Sally want to do at that time.
QPRT Reduction in Value of Gift. Because Sam and Sally have given a future interest to their children in their residence, Sam and Sally have to file a gift tax return reporting the amount of the gifts made to their children. The accountant must calculate the value of the gifts. First, the house is reduced in value from $1,500,000 to $1,000,000 due to the property settlement agreement. Because the children will not receive the gift of the residence for several years (the time periods set forth in the QPRTs), the value of the gifts is further reduced as a result of the use of the QPRT. If someone agrees to pay you $100 ten years from now, you would not give them $100 today. You may give them $50 because for you, the present value of $100 ten years from now is $50. The IRS has tables to calculate this. As a result of these calculations, the value of the QPRT gifts to the children of the entire residence total $500,000, a combined reduction of $1,000,000. Because Sam and Sally each made a gift worth $250,000, if our majority is correct, they each reduce their per person $1,000,000 gift tax exemption by $250,000 each, but none of their future estate tax exemption.
Magic of 2010. According to our majority, the opportunity of 2010 is that any gift in 2010 under current law does not reduce the future $1,000,000 estate tax exemption. Thus, if Sam and Sally complete these gifts in 2010, they still will each have a $1,000,000 estate tax exemption in 2011. But, if they were to make this gift in January of 2011, their joint gift of $500,000 would be deducted from their $1,000,000 estate tax exemptions, leaving them $500,000 less in total combined exemptions from estate taxes. Of course, this process provides even more tax reductions for residences worth more than $1, 500,000.
Estate Tax Eliminated. Sam and Sally both live their life expectancies and so now the trusts for their children own their personal residence. When Sam and Sally die, then their personal residence is completely out of their taxable estate and Sam and Sally children own the residence which is what Sam and Sally wanted from the beginning. Their children can keep or sell the residence as determined by their children. The children could have higher capital gain taxes as a result of the QPRT, unless they use available exemptions or deferrals from capital gain taxes. Therefore, rather than having a taxable estate of $3,500,000, now that Sam and Sally’s 1,500,000 residence is out of their taxable estate, their taxable estate is $2,000,000. This is true even if the value of the residence grew to $2,000,000 or more before they both died. Because they made their QPRT gifts in 2010, they still each have their $1,000,000 estate tax exemptions under the majority view and they no longer have a taxable estate ($2,000,000 estate less $2,000,000 in exemptions). Their estate saves $750,000 in estate taxes.
Must survive the time period. If Sam or Sally do not live to their life expectancy and do not survive the time period of the QPRT, then the discounted value of their share of the residence is still part of their taxable estate. They may have not benefited from the planning fees and costs for the QPRTs, but their tax liability is the same as if they did not use the QPRTs and their taxes are less because of the property settlement agreement. If they survive the time period, then they may rent the house from the trusts for their children and this rent will enable them to transfer more wealth to their children without any estate taxes on this transfer and such rent payments will not be subject to a gift tax or a reduction of their exemption from gift taxes.
Must Start Now. It takes about 90 days to obtain such appraisals and the transfers must be done before January 1, 2011 to take advantage of this window of opportunity. We will still use these strategies in 2011, but they will not give you the same extraordinary level of benefits as they do in 2010. Even if the minority is correct, you have removed a valuable asset when real estate prices are low and have removed all of the appreciation in the real estate over a several year period from your estate.
Editor Notes:
Join us on 11-11-10 for a Free Live Webcast - Estate planning Strategies for the 11th Hour. What You Should Be Doing for Your Clients Before 2010 Ends.
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