High net worth families should be quite concerned about the federal estate tax. This tax can alter the trajectory of your family’s financial future, because it carries a very hefty 40 percent maximum rate.
There is a federal estate tax credit or exclusion. This is the amount that can be transferred tax-free to people other than your spouse.
For the rest of 2016, the estate tax exclusion stands at $5.45 million. There are annual adjustments to account for inflation, so the exclusion is somewhat higher in 2017 it is $5.49 million.
You do not have to worry about using your exclusion to transfer assets to your spouse free of taxation, because there is an unlimited marital deduction. This allows you to leave unlimited money and/or property to your spouse free of the estate tax, as long as you and your spouse are American citizens.
It would make sense to consider lifetime gift giving as a way to avoid the federal estate tax. People did this for a few years after the original enactment of the death tax, but a gift tax was installed to close the loophole. The $5.49 exclusion encompasses large gifts that you give while you are living along with the value of your estate.
If you are exposed to the federal transfer taxes, you must take steps to gain estate tax efficiency. Your home may be your most valuable asset, so you would benefit greatly if you could reduce its taxable value.
This could potentially be done through the creation of a legal device called a qualified personal residence trust. Let’s look at the details.
No Initial Disruption
To implement this strategy, you fund the qualified personal residence trust with your home. When you create the trust agreement, you set a term. This interim is called the retained income period.
During this period of time, you remain in the home as usual, so you do not experience any immediate disruptions to your living arrangements.
You name a beneficiary who will assume ownership of the home after the term of the trust expires.
When you fund the trust with your home, you are removing the value of the home from your taxable estate. That is the good news, but on the downside, you are giving a taxable gift to the beneficiary.
If you are giving a taxable gift, why is this a viable tax efficiency strategy? A qualified personal residence trust provides tax efficiency because the value of the gift will be far less than its true fair market value.
To explain why there is a tax discount, imagine trying to sell your home to a neutral buyer. You tell the prospective buyers that they cannot assume ownership of the home for fifteen years. No one would pay full fair market value under these circumstances.
The Internal Revenue Service takes this rationale into account when the taxable value of the gift is being calculated. If you set a retained income period of ten or fifteen years, the taxable value of the gift would be considerably less than the true market value of the home.
At the end of the trust term, the beneficiary would assume ownership of the property, and the gift tax liability would be greatly reduced. If the taxable value of the gift was within the amount of your available unified lifetime gift and estate tax exclusion, there would be no tax exposure at all.
The longer you stay in the home the better from a tax perspective, because the taxable value of the gift is based on the duration of the retained income period. However, if you die before the expiration of the retained income period, the strategy falls apart, and the property goes back into your taxable estate.
Schedule an Estate Planning Consultation
Los Angeles County is home to a very high concentration of people who have been able to accumulate a significant store of wealth. There are a lot of individuals in the area who are exposed to the federal estate tax. A qualified personal residence trust can be part of a wealth preservation plan, but there are other steps that could be taken to gain estate tax efficiency.
If you would like to discuss taxation or any other estate planning concern with a licensed professional, our doors are open. We offer personalized attention, and we would be glad to discuss your unique situation with you, whether you are exposed to the estate tax or not.
If you are interested in the possibility of working with our firm after learning these facts, please select our “Workshops” tab to RSVP for a free estate planning workshop. At that workshop you will be offered a free one-hour consultation with an attorney: https://collinslawgroup.comseminars/