From the June 2006 issue of Investment Advisor • Subscribe!

Transfer Time, Part 1

A review of strategies clients can use for transferring wealth

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One of the significant issues that will be faced by retiring baby boomers is how to keep their accumulated wealth within their families. Such clients are interested in techniques that will allow large transfers to the younger generation with significant estate tax savings. The purpose of this two part article (part two will appear in the July issue of Investment Advisor) is to highlight the common estate planning strategies used to accomplish this goal as well as their benefits and drawbacks.

Equalization of Assets

The Internal Revenue Code currently permits each estate to deduct a statutory exemption in the determination of the taxable estate. For the year 2006, the exemption stands at $2 million; it increases in 2009 to $3.5 million. Subject to any adjustments in current law there will be no estate tax in 2010 and then the exemption reverts to $1 million in 2011. Therefore, initial tax planning should provide that each individual have as a net estate (commonly defined as gross estate less the sum of debts, funeral and administrative expenses, and other allowable deductions) equal to at least the foregoing exemption. This permits the decedent to pass on to a trust for the surviving spouse a specific sum with the income payable to that person for life. The principal, however, will pass free of estate tax to the next generation since the surviving spouse will not be considered to have unlimited authority over those assets. Recall, however, that the trustee can make principal distributions to the surviving spouse, if necessary, to pay for health or maintenance costs.

The volatility of the stock market has forced investors to rethink how to invest their money. That's led to a burst of refurbishing of personal residences due to the low interest rates on mortgages and home equity loans. This applies not only to the primary residence but to the second home, too. The use of a qualified personal residence trust ("QPRT") has been a way of transferring appreciated real estate to the next generation.

A QPRT is an irrevocable trust established for a specific number of years and is set up by the parents who own the house. During the term of the trust they retain the right to live in the home and derive the same benefits they had of having the residence prior to the trust's creation. At the end of the trust's term, the residence belongs to the beneficiaries, normally the children. The parents may continue to live in the home but must pay the children, as the owner-landlord, a fair market rental.

The positive aspects to this estate-planning tool are that the grantors--the parents--are considered to have made a completed gift when the trust is created. The gift is not at the full fair market value of the property but must be discounted for reasons including the age of the parents at the time of the gift, the term of the trust, and the AFR (Applicable Federal Rate) used in determining the discount to be applied to the home's fair market value. The same strategy applies to the second (vacation) home that would be set up in a separate QPRT. In order to effectuate a QPRT the grantors must be in full control of the property, i.e., it should not be partially rented. Furthermore, the grantor(s) must outlive the QPRT or else the transaction is reversed and the property is included in his/their estate(s). If the home is sold the trust will not lose its utility as an estate-planning tool if there is a replacement of property within two years (either before or after) of the sale and before the term of the trust expires. Alternatively, instead of replacing the residence, the cash received on its sale can be remitted in installments to the grantor in the form of an annuity until the trust's term expires. This action would permit the QPRT to continue.

Grantor Retained Annuity Trust

If real estate is not a significant portion of the estate but there are other assets that have appreciated, or are expected to appreciate soon, a different spin on the qualified personal residence trust is the grantor retained annuity trust ("GRAT"). Under this plan the grantor (parent) places the property into a trust for a specified period of time. During that period the grantor will receive an annuity. Upon completion of the term the ownership of the property transfers to the beneficiary (child). These characteristics are similar to a QPRT. Other similarities to the QPRT include:

o the complete gift which is computed by applying the Applicable Federal Rate (AFR) at the time of the gift;

o the appreciation on the property above the discounted value as computed by applying the AFR is free of gift tax;

o the grantor must live beyond the term of the GRAT.

Interest rates play a significant role in the use of QPRTs and GRATs in determining the reported amounts when transferring assets from one generation to another on the gift tax returns. The higher the interest rate applied to the value of the transferred property, the greater the discount applied to the principal being gifted. The greater discount means that a lesser amount of the lifetime exemption is being consumed on a current basis.

Intentionally Defective Grantor Trust

Another estate planning tool that also illustrates the use of low interest rates is found in an intentionally defective grantor trust ("IDGT"). In this situation, the parent sells an asset (e.g., an interest in a family real estate partnership) to a trust for an installment note with a low interest rate (per the AFR). Only interest is required to be paid on a current basis while the principal may have a single balloon payment at a future date, perhaps in 10 or 15 years. The IDGT is set up as a grantor trust so that there is no gain recognized by the parent on the sale to the trust nor is there any income/deduction recognized when the interest payments are made. The low interest rate inures to the beneficiary as all cash received in excess of the interest payments should be invested, presumably at a rate higher than the AFR required on the note. This would allow the trust/beneficiary to accumulate funds to pay off the principal of the note when it comes due at the end of the trust's term or on the death of the grantor, whichever is earlier.

If the property significantly increases in value after the transfer, all of the appreciation in excess of the interest and principal, which must be paid, belongs to the beneficiary free of all estate and gift taxes. Sometimes planning with an IDGT is combined with buying insurance on the grantor to cover the principal when it comes due. In such a case the intention is to keep renewing the note at the end of its term so it remains an open receivable to the parent at his death. At that point the principal must be paid. If done properly, the estate asset is limited to the unpaid principal while all of the appreciation subsequent to establishing the IDGT has been passed to the beneficiary. Alternately, if it is evident that the grantor is near death, consideration should be given to terminating the IDGT and having the property repurchased by the grantor for cash, issuance of a note, or a combination of both. This action will put the original asset back into the estate at am amount equal to the higher value with a reduction for the offsetting debt. During the interim years the appreciation from the trust's inception until its termination had been transferred to the beneficiary.

As previously noted for income tax reporting, the intentionally defective grantor trust is considered a grantor trust. Any income derived from the trust is taxable to the parent on his return. All income distributions from the trust are made to the beneficiary. Thus the parent has the pleasure of reducing his estate through the sale of the asset to the trust and paying all income taxes on such income albeit such income is paid to the trust and/or the trust's beneficiary. For those who fully understand the use of an IDGT the payment of income taxes by the parent on the trust's income is another means of making a tax-free gift to the beneficiary.

The following table lists the Applicable Federal Rates for January 2006 that are applicable to loans:

The rates run from 4.29% to 4.73% depending upon the term of the note and payment schedule. The short-term rates cover loan maturities of three years or less; mid-term rates apply to maturities of more than three years but less than nine years; long-term rates apply to loans maturing longer than nine years. To the extent these rates are applied to the intra-family note (between grantor and trust), any principal invested above the AFR used in the instant case would result in appreciation to the beneficiary. Furthermore, the value of the transferred asset would be discounted, in part, because of the rate chosen from the foregoing tables applied to the note issued between the parties. The greater the discount applied, the more principal that can be covered in the transfer.

To illustrate the use of an intentionally defective grantor trust, assume that on January 1, 2006, the parent sells a 10% interest in a family limited liability company to a child in exchange for a discounted note of $208,000. Under the term of the note only interest is payable annually at the AFR of 4.73% until maturity in 10 years, when the principal is due. Since the IDGT is a grantor trust, there is no reported gain on the sale nor is there any income/deduction on the annual interest payment because, for income tax purposes, the intentionally defective grantor trust is ignored. It is considered self-dealing. The LLC's sole asset is a fully depreciated building which generates enough cash that the 10% interest represents monthly distributions from the LLC totaling $40,000 per year.

Since the required annual interest payment is only $9,838, the excess cash received should be invested at a higher rate that would belong to the beneficiary. If the additional income remains in the trust it would be taxable to the parent together with the income from the rental property, so that at the end of the trust's term all appreciation would pass to the beneficiary free of any income and estate taxes. The parent only has the discounted note as an asset while the appreciation in the real estate now belongs to the child.

Estate planning requires a degree of sophistication and cannot be done in a vacuum. The advisor should be knowledgeable enough to review different strategies in devising proper plans with clients. Next month, we will review other ways to transfer accumulated wealth.

I. Jay Safier, CPA, is a principal in the New York accounting firm Rosen Seymour Shapss Martin & Company LLP, where he is actively involved in advising high net-worth individuals and owners of closely-held businesses on a broad range of corporate, accounting and auditing, tax, estate and business matters. He can be reached at

The QPRT, Illustrated

What are the benefits of a qualified personal residence trust (QPRT) in estate planning? Here is an illustration.

Assume clients H and W jointly own their primary residence purchased many years ago at a cost of $300,000 and neither owns more than a 50% interest. The appraised gross value of the home on January 1, 2006 is $1 million and each of them establishes a qualified personal residence trust for his/her respective share in the property. The beneficiaries of the trusts are the couple's children. The property is transferred to the QPRTs on January 2, 2006. [For ease of illustration state gift taxes are ignored.]

Assuming the parents outlive the term of the trust, they have successfully passed out $1 million in value from their combined estates without any out-of-pocket cost and have unified credits of $298,447 and $295,329, respectively, to be applied against gift taxes on future gifts to the children of $823,272 and $813,527, respectively, before they must pay any gift taxes. This is in excess of the annual gift exclusion of $12,000 per donee per year.

The primary advantage of a QPRT is that if the grantors outlive the term of the trust all of the appreciation from inception of the trust to their death will escape estate tax. If they continue to live in the residence once the term has expired, their estates are further reduced by the monthly rental payments they make, which must be at a fair market rate. Conversely, the beneficiaries assume the parents' tax basis for the home. Therefore the stepped-up basis they would have received if the property stayed in the parents' estates is forfeited. However, given that the current capital gains tax rate is significantly lower than the estate tax rate, the beneficiaries should still be ahead on a net cash basis if the property was sold.

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