Yesterday’s post covered 13 options for homeowners wanting to transfer their personal residence (“PR”) within their circle of family or friends after death. Today, we continue the discussion by presenting 14 additional options more appropriate for families that are anticipating an estate or gift tax liability in the future.
The strategies discussed below increase the likelihood of an audit. Since they all involve some form of gifting to close family or friends, the IRS wants to be sure that the original owner has actually relinquished control of the gifted asset and has not set these instruments up “for show”.
But first, let’s discuss why actively giving away a PR during your life is preferable to passively waiting for it to pass through your estate.
Should I Pay Gift Tax or Estate Tax?
Despite having the same 35% maximum rates, paying a gift tax is less expensive than paying an estate tax. This is because gift taxes are “tax exclusive”, whereas estate taxes are “tax inclusive”.
In other words, a lifetime gift results in a gift tax on the value of the gifted asset only. On the other hand, all assets remaining in one’s estate after death are subject to estate tax, including any taxes saved by not making a lifetime gift.
Here’s an example. Let’s assume you have used up your $5 million exemption during your lifetime and still wish to give your $1 million PR to your kids.
- If you gift the PR during your life, you would owe 35% of the value of the gift, or approximately $350,000 in gift taxes. This means that $1,350,000 would go out of your pocket – the $1 million house plus the $350,000 in taxes.
- If instead you wait until death to gift the PR, you would owe 35% of what is remaining in the estate, or approximately $472,500 in estate taxes. This is higher because both the $1 million PR and the $350,000 you saved by not paying any gift taxes are still part of your estate. The 35% is applied to $1,350,000.
Now that you are (hopefully) convinced of the power of lifetime giving, let’s discuss our advanced strategies.
Outright Gift or Sale
Since every U.S. citizen can currently give up to $5 million free of estate and gift tax during his or her lifetime, the PR owner could opt to simply give the PR away. Here are three ways to do so:
- Direct Inter-Vivos Gift – The owner gives the PR directly to one or more heirs “inter-vivos” (i.e. during his or her lifetime).
- Low-Interest or No-Interest Loan – The owner sells the PR directly to one or more heirs for a low-interest or no-interest loan. Any income lost by not charging a market rate of interest is treated as a gift. Other strategies related to this theme are discussed below.
- “Crummey” Trust – This is an irrevocable trust which can be held on behalf of minor or adult heirs. With this, the owner creates the trust and then gives the PR to it outright. However, the twist is that any gift made to the trust must first be offered to and rejected in writing by the beneficiary.
Transfer to Specialized Trusts
The PR owner could instead create certain specialized trusts to receive the PR as a gift. In exchange, the owner keeps or designates a right to any trust income over a period of time defined in the instrument. These instruments follow this arrangement, along with the stated variations:
- Grantor Retained Trust – The PR owner must live beyond the period of time defined in the instrument to gain any gift and estate tax savings.
- Qualified Personal Residence Trust (QPRT) – This has the same requirement as the grantor retained trust.
- Sale to Intentionally Defective Grantor Trust (IDGT) – “Defective” since original owner, and not the trust, pays taxes on any trust income.
- Charitable Remainder Trust (CRT) – With this, the owner can get income for life, and then the charity gets the remaining assets.
- Charitable Lead Trust (CLT) – This is the opposite of the CRT – most commonly, the charity gets income for the owner’s life, then the owner’s heirs get the remaining assets outright.
Shares of Family Entities
The owner could also give the PR to a “family entity”. In exchange, the owner receives shares or a percentage of the entity. If the owner then gives some shares away to family members, all the shares are permitted a discounted value by the IRS mainly because very few outsiders would want to buy into this arrangement.
The two main family entities are:
- Family Limited Partnerships (FLPs)
- Family Limited Liability Companies (FLLCs)
As opposed to the selling the PR to the heir for low or no interest loan from above, the owner could instead charge at least the then current “Applicable Federal Rate” of interest to the heir. The heir can then pay down the loan in the following ways:
- Installment Sale – Heir pays installments over time like a traditional mortgage.
- Self-Cancelling Installment Note (SCIN) – Heir pays installments as above, except the note is cancelled if the original owner dies before it is paid off.
- Private Annuity – Heir pays installments for the remainder of the original owner’s life.
- Sale or Gift - Leasebacks – PR to heir, then original owner who remains in the PR must pay market-level rent.
These transactions, while most commonly used between families, do not require familial participation.
Some final points to remember:
- These two posts do not reflect an exhaustive list of your options.
- Most of these techniques are also available for other assets.
While choosing from this many alternatives can be a daunting task, you also have the flexibility to transfer your PR in a way that meets your ideals and can be of the most benefit to your loved ones.
- Gifts of Real Estate really are Gifts – and the IRS is looking for them (njelderlawestateplanning.com)
- IRS Cracks Down on Gifts of Real Estate (ncestateplanningblog.com)
- Helping Friends and Family Financially Without Gift Tax Consequences (lawprofessors.typepad.com)