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