In “Simon Says: Love Your Legacy,’’ Saul Simon’s guide to achieving financial well-being, an entire chapter is devoted to trusts, such as the complex and tax advantageous split interest trusts, which include the personal residence trust (PRT).
Simon, a certified financial planner affiliated with Lincoln Financial Advisors Corp. and president of Simon Financial Group in Edison, N.J., and his colleague, Brad Kaplan, an attorney in New York and New Jersey who concentrates in trusts and estates, taxation and business planning, recently discussed PRTs—trusts that can save considerable money for the right client—in an interview with Private Wealth.
The transfer of a residence to a personal residence trust is considered a completed gift, Simon said, and for tax purposes the goal is to minimize the value of the gift. When a grantor retains interest in the PRT through residence, the trust is known as a qualified personal residence trust (QPRT).
It’s up to financial advisors to help clients understand which trust is appropriate, Simon and Kaplan said.
“Residence trusts are a very complicated area that require a great amount of thought and consideration. That being said, you should absolutely not use a residence trust where the owner of the property has a very low tax basis and … will not be subject to the federal estate tax,’’ Simon said.
The federal estate tax exemption is currently $5.43 million; at present, the top federal estate tax rate is 40 percent. A husband and wife get their own exemption, enabling a couple to give away $10.86 million tax-free if they have not made prior lifetime gifts.
“The purpose of using a residence type of trust, which can either be a personal residence and/or a second type of home that is used as a magnet that attracts the family and is anticipated to appreciate in value, is, you want to remove these large assets out of the estate so that it is not taxed as part of the estate tax,’’ Simon said.
Once the trust is funded with the house, the residence and any future appreciation of the residence is excluded from the estate. In QPRTs, the owner agrees to an upfront time limit on occupancy in the residence and must forfeit ownership at the end of the QPRT term.
Personal residence trusts are irrevocable split interest trusts and constitute a completed gift, Simon writes in his book. A gift is valued at fair market value, less retained interest, which lowers the gift’s value, which lowers the tax rate.
“Your decision to create a QPRT requires balancing the consequences of relinquishing ownership to your beneficiaries against the potential estate tax savings, based in part on current interest rates,’’ Simon writes in his book.
QPRTs are recommended “where the clients do not have assets that are easily transferable out of the taxable estate, but [where] the residence comprises a good portion of value.’’
One of Simon’s clients is a doctor who has accumulated $15 million in qualified assets, plus a home in New Jersey worth $5 million that can be appraised for $4 million and a home in Florida worth $2.5 million. The physician is divorced with two sons and has a medical practice in New Jersey that is starting to slow because he is working less. As Simon put it, “He wants to maintain the New Jersey practice because he wants to have a purpose. As such, becoming a Florida resident is not an option.
“From a gift-giving perspective, we cannot transfer the qualified assets. The Florida property is a rental property that is bringing in excellent cash flow. He is going to have an estate subject to federal estate tax, so we want to try and preserve as much of his exemption as possible, but we would like to get the New Jersey home out of his taxable assets,’’ he said.
“The gift is valued at the fair market value of the residence, less the value of any retained interest,’’ said Simon, who noted in his book that under IRS Code section 7520, “if the retained interest has value, this value will be greater than zero, and the corresponding value is diminished.’’
Kaplan outlined a scenario that allows a client to lower gift tax costs through a QPRT: “A client establishes a seven-year qualified personal residence trust using a home worth $1 million to live in for seven years. Depending on the appraised value of the home and applicable interest rates, the gift of the remainder interest would be lower—let us say for this illustration, $700,000.
“And let us say I live well past the seven years. Say I live 20 years. Now the house will be worth $1.4 million. I have now transferred $1.4 million out of my taxable estate at a gift tax cost of $700,000. … I have also eliminated a tax on $700,000 of assets.’’
Kaplan said with the increase of the federal estate tax exemption to $5.43 million per person, “the group of people that are out there that will be subject to [the federal estate tax] is getting smaller and smaller. More people are concentrating on state death taxes,” Kaplan said.
In New Jersey, for example, the death tax exemption is $675,000.
“Where people are not going to be subject to the federal estate tax, they should not be too quick to transfer assets to avoid state death tax, where the asset has a low tax basis,” Kaplan said. “For many people, their homes are both their largest asset and an asset that also has a low tax basis. As such, it is an issue that comes up much more frequently as contrasted with people having investment accounts.’’
Kaplan offered this example: In a $4 million estate, with a home valued at $2 million and a tax basis of only $100,000, the client will not be subject to the federal estate tax, but will be subject to the New Jersey estate tax on everything above $675,000.
At the client’s death, with the house still in his name, the New Jersey estate tax would be around $332,500. But his children could sell the home for $2 million and have no capital gain. If the client transfers the house before death, then the New Jersey estate tax would only be $132,500. But, if the children sell the house for $2 million, their capital gains tax could be around $570,000, Kaplan said.
New Jersey, New York, Connecticut, Los Angeles and parts of Florida have populations concerned with the federal estate tax, Kaplan said, and so personal residence trusts make sense for their estate planning. For many others, Kaplan said, the above-mentioned tax-saving options apply.
