If you are exposed to the estate tax, a qualified personal residence trust could help you gain estate tax efficiency. Before we provide an explanation, we should look at the federal transfer tax parameters so that you can determine the extent of your liability.
Federal Estate Tax
There is a federal estate tax credit or exclusion. This is the amount that you can transfer to others tax-free. During the 2016 calendar year, the federal estate tax exclusion is $5.45 million. There are annual adjustments to account for inflation, so it may go up a bit next year.
It should be noted that there is an unlimited marital deduction. You can transfer unlimited assets to your spouse free of the estate tax. The $5.45 million exclusion applies to transfers to people other than your spouse.
The top rate of the federal estate tax is 40 percent, so we are talking about a very significant source of asset erosion.
Federal Gift Tax
The federal gift tax comes into play when you are looking at qualified personal residence trusts, so we should explain this tax as well.
The tax man does not want you to give gifts while you are living to avoid the estate tax, so we have a federal gift tax. This tax is unified with the federal estate tax. The $5.45 million exclusion applies to lifetime gifts that you give along with the value of the estate that you are passing on to your heirs.
This tax carries the same 40 percent maximum rate, and the unlimited marital deduction extends to lifetime gifting.
Qualified Personal Residence Trusts
Now that we have shared the necessary background information, we can look at qualified personal residence trusts. The idea is to fund the trust with your home. You name a beneficiary who will assume ownership of the home after the trust term expires. This term is referred to as the retained income period.
During the retained income period, you continue to reside in the home as usual. You decide on the length of this term. It can be five years, 10 years, 15 years, or whatever you choose.
When you convey the home into the qualified personal residence trust, you are removing the home from your estate for tax purposes. That’s the good news. The bad news is that you are giving a taxable gift to the beneficiary.
However, the taxable value of the gift is going to be considerably less than the actual market value of the home. This is because of the retained income period.
Imagine trying to sell your home on the open market. A buyer is interested, but you tell her that she cannot assume ownership of the home for 15 years. The buyer would be unwilling to pay the full market value under that stipulation.
The Internal Revenue Service takes this dynamic into account when the taxable value of the gift is being calculated. As a result, the taxable value is greatly reduced.
When the transfer takes place at the end of the retained income period, the gift tax will be applicable, but the tax savings will be considerable.
There is something to consider when you are setting the duration of the trust term. If you were to pass away before the retained income period had expired, the strategy would fail, and the home would once again become part of your taxable estate.
The longer you stay in the home, the greater the tax savings will be. However, you do have to be conservative in light of the fact that the strategy can fall apart if you pass away before the expiration of the term.
Explore Estate Tax Efficiency Strategies
High net worth individuals who are exposed to federal transfer taxes can gain tax efficiency through the creation of a qualified personal residence trust. At the same time, there are other strategies that can be implemented to reduce your estate tax burden. The ideal estate tax efficiency plan will depend upon the circumstances.
When you execute the appropriate strategy properly, you can significantly reduce your exposure to the federal death tax. Ultimately, you will maximize the legacy that you leave behind to the people that you love.
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