Planning for the Home

Transcription

1 Planning for the Home What to Do With the Old One Wednesday, March 19, :00 2:30 PM Eastern Emanuel J. Kallina, II, JD, LLM Kallina & Associates, LLC 1122 Kenilworth Drive, Suite 507 Towson, MD Presented by the National Committee on Planned Giving

2 I. Qualified Personal Residence Trusts ( QPRT ) A QPRT is an irrevocable trust which holds title to an individual s principal residence or vacation home. Typically, a husband and wife with a combined gross estate over $4M will consider using the QPRT in order to pass their principal residence or vacation home estate and gift tax free to their children. The husband and wife, as the grantors, retain the right to live in the property for a term of years. As such, the trust is a grantor trust and the grantor is entitled to deduct mortgage interest and real estate taxes on his or her individual return. At the end of the term of years, the property is held in further trust, or transferred to the remaindermen, whether that is an individual or an entity such as a trust or partnership. When the grantor transfers the property to the trust, he or she makes a gift of the remainder interest in the property. The amount of the gift is determined by subtracting the fair market value of the property from the present value of the grantor s retained right to use the property for the term of the trust. The gift is reported on a gift tax return filed by the grantor for the year of the gift. If the remainder beneficiary of the trust is, for example, the grandchildren, no GSTT exemptions can be allocated on the gift tax return since the gift is of a future interest in property. GSST exemptions, however, can be allocated to the gift at the end of the term. If the grantor dies during the term of the trust, the property is includible in the grantor's estate and the estate receives a credit for the exemption used on the initial transfer. If the grantor survives the term of the trust, the value of the property and all future appreciation are removed from the grantor's estate. If the property is sold during the term of the trust and the property meets the definition of a principal residence, the grantor can take advantage of the $250,000 capital gain exclusion available to single taxpayers or the $500,000 capital gain exclusion available to married tax payers. Upon the sale of the property during the trust term, the trustee can purchase another residence or can invest the proceeds and pay the grantor an annuity (the QPRT morphs into being a grantor retained annuity trust ). The property can be mortgaged while it is owned by the trust but the proceeds of the loan must be used for improvements to the property and not for an unrelated purpose. The trustee should be careful because the QPRT is restricted by the cash it may hold. Generally, a QPRT is only permitted to hold enough cash to pay for six month s worth of expenses or for improvements that are to be made within six months. Since the transfer of the residence to the trust is a gift to the remainder beneficiaries, the beneficiaries take the grantor's basis in the property and do not receive a step-up in basis. Thus, the sale of the property by the remaindermen after the end of the term of the QPRT could result in large capital gains to the remaindermen. A QPRT can hold the principal residence of the grantor, or one other residence of the grantor, or a fractional interest in either. A separate QPRT is necessary for each residence or fractional interest and a grantor can create only two QPRTs at any one time. The trust cannot hold any other assets other than a residence or a cooperative, but can own adjacent land and structures as are reasonably appropriate. At the end of the trust term, the trustee has thirty (30) days to distribute the property. The grantor can continue to reside in the property so long as he pays fair market rent to the remaindermen. If the grantor so desired, he or she could repurchase the residence after, but not during, the term of the trust. The main advantages to the use of a QPRT are: 1. Generally a QRPT is designed so that minimal gift, estate, or transfer taxes are imposed upon creation. 2. A QPRT freezes the value of the residence at its value on the date of transfer to the trust, so that future appreciation is not in the estate of the grantor if the grantor survives the term. 3. Setting up a QPRT is a no lose proposition: if the grantor survives the term, the property and appreciation are out the grantor s estate; if the grantor dies during the term, the estate tax consequences are no worse than if the QPRT had not be created. 4. By structuring the QPRT correctly, additional estate and gift tax planning can be achieved. 5. A QPRT is not considered to be a tax shelter, although the reduction of taxes is its only purpose, and instead is blessed by the Internal Revenue Code and the IRS. 2

3 Some disadvantages of a QPRT are: 1. The trust must be irrevocable. 2. The grantor might die during the trust term, thus defeating the purpose of the QPRT. 3. The remainder beneficiaries do not receive a step-up in basis to fair market value. 4. The grantor has no legal right to occupy property after the trust term. 5. The grantor must pay rent to continue residing in the property after the term, assuming that the remaindermen will allow the grantor to do so. 6. The property being given to the QPRT must be appraised, so there are costs for the appraisal as well as the preparation of the deed and the trust document. In the past, some donors have expressed irritation with having to rely upon the good graces of their children to continue living in their own home. Further, the idea of paying rent to children has caused a violent and adverse reaction on the part of more than one client. Professional advisors have also commented, after running numerous spreadsheets, that the economic benefits of a QPRT are questionable for the family unit as a whole, given the fact that mom and dad will be paying income taxable rent to the kids, which is not deductible by mom and dad. One ingenious person suggested a solution to many of the major disadvantages of a QPRT. Normally, clients who are considering a QPRT have done basic estate planning, such as a will and an irrevocable life insurance trust ( ILIT ). Typically, the trustee of the ILIT is a person friendly to the grantor. If the QPRT were to dump into the ILIT (as the remainderman) at the end of the term, the grantor would be relying upon a friendly trustee to allow him or her to continue living in the residence. Further, the rent paid by the grantor to the ILIT would not be taxable to anyone, since the grantor effectively is paying rent to himself or herself (most ILITs are grantor trusts). Finally, as icing on the cake, the trustee of the ILIT could use the rent to pay insurance premiums, at no estate, gift, or generation-skipping cost -- not even a reduction of the unified credit or annual exclusion. This structure can have significant advantages to a grantor; in effect, with a number of the negatives being eliminated, there is no downside to the transaction other than transactional costs. CASE STUDY: In 1977, Mom and Dad (now both age 65) built a wonderful vacation home in Tahoe, NV, a year-round facility, for $250,000. Their three children, along with the grandchildren, are constantly visiting the home, and the property holds many wonderful memories. The vacation home is a honey pot and attracts the entire family. Mom and Dad want to make absolutely certain that this property stays in the family for generations, but are concerned that the rapid appreciation of the property over the years will force it to be sold in order to pay estate taxes. Right now, the home is worth $2,000,000. Their professional advisor has suggested that they each create a QPRT. When Mom and Dad transfer their vacation home to their respective QPRTs, the underlying property will be appraised, but since neither Mom nor Dad owns a majority interest in the home, there will be a discount for minority interest and lack of marketability and liquidity. Let s assume the appraiser values each 50% interest being transferred into a QPRT at $750,000, a 25% discount from the underlying fair market value. Mom and Dad will transfer their interest in the home to each one of their trusts for a term of 15 years. Mom and Dad each will use up a little less than $200,000 of their lifetime exemption, based upon a computer analysis (see the attached Exhibit I). If Mom and/or Dad survive 15 years, their estate planning goals will have been achieved. However, Mom and Dad are concerned that the property will become so valuable in their children s estates, that the property will have to be sold to pay estate taxes when their children die. Their professional advisor recommends that Mom and Dad make the children the remainderman of each QPRT, and that the children sell their interest in the remainder interest, one year and one day after the creation of the QPRT. The children will sell to the 2 life ILIT which Mom and Dad created earlier, which was designed as a dynasty trust -- that is, the assets would never be subject to estate, gift, and generation-skipping taxes. At the time of the sale by the children, their remainder interest will be a little over $467,000, so the ILIT will issue its promissory note, with interest only at the AFR, and all interest and principal will be due at the death of the survivor of Mom and Dad. There will be no 3

4 income tax consequences at the time of the sale, but long-term capital gains on the sale and ordinary income taxes on the accumulated interest will be due at the time the promissory note is paid. Since the ultimate remainder of the QPRT at the end of the term will be the ILIT, the benefits discussed above will exist: Mom and Dad don t need the kids permission to live there, the rent they pay will not be taxable, and the rent can be used to pay for insurance premiums, estate and gift tax free, and there are minimal estate and gift tax implications when the QPRT is created. In addition, the honey pot will stay in the family forever, and never need to be sold to pay estate or generation-skipping taxes. [CAVEAT TO NON-LAWYERS: There are tax risks associated with this transaction which need to be addressed fully by the grantor and his or her tax counsel. Don t try to do this without the help of expert tax counsel who can advise as to all positives and negatives.] II. The Use of Revocable Living Trusts ( RLTs ) Revocable trusts are an estate planning tool frequently used by individuals to hold and manage their assets during their lives and control the disposition of assets at death. In order to transfer real property to a revocable trust, a deed vesting title in the trustee of the trust is necessary. The grantor of a revocable trust is typically the trustee and retains complete control over the assets in the trust. The grantor also retains the right to amend or revoke the RLT. As such, the grantor has the ability to sell, transfer, or mortgage the property. In addition, the grantor is entitled to all income tax deductions associated with the property, including mortgage interest and real estate taxes. The grantor can also take advantage of the capital gains exclusion on the sale of a principal residence even though title is vested in the RLT. Generally, there are no transfer or recordation taxes on the transfer of real property to a RLT. The use of a RLT to own property has some distinct advantages. A revocable trust can have more than one trustee to act with respect to the property and can name successor or back-up trustees. If a grantor is incapacitated or unable to act for any reason, a co-trustee or successor trustee can act for him or her. A co-trustee or successor trustee would not need a special power of attorney to carry out a transaction involving the property, assuming the property was titled in the name of the RLT. This can be especially important when the grantor becomes incompetent and cannot complete a sale or mortgage and is not legally able to execute a power of attorney. In addition, real property owned by a revocable trust is not subject to probate proceedings, which can be costly and time-consuming. Property owned by a RLT can be distributed by the trustee immediately after the death of the grantor. The use of a revocable trust to own property located in different states is advantageous. The trustee of the trust can sell or transfer the property without the commencement of ancillary probate proceedings in each state, which would be necessary if the grantor owned the property individually. Finally, the property receives a step-up in basis on the death of the grantor even though the property is owned by a trust. RLTs do not offer any special tax advantages or any creditor protection. Furthermore, the transfer of property to a revocable trust will break the special protection afforded a husband and wife who own property jointly. A married couple typically owns property as tenants by the entireties, which means that the property will not be subject to the creditors of one spouse. Transferring a one-half interest or all of the property to a revocable trust breaks the tenancy and subjects the property to the claims of the creditors of the spouse owning the revocable trust. The use of a joint revocable trust, which is usually a trust between two individuals who are married, does not solve the creditor issue. A transfer of real property to a joint revocable trust will break the tenancy of ownership even if the grantors are married to one another. A joint revocable trust is typically used by married individuals to combine their assets. Although it does not give protection from creditors, it is a useful tool in planning for individuals whose estates may be subject to estate tax. Assets can be allocated within the trust to a credit shelter trust without the need for disclaimers or the division of assts based on who is likely to die first. III. Gifting Remainder Interests to Charity and Retaining a Life Estate There are several methods of gifting a remainder interest in real property while retaining a life interest. An easy and cost effective method is a life estate deed. An individual can transfer property to himself or herself for life with the remainder to a charitable organization. The individual can hold the life estate with the power to sell, mortgage, transfer or otherwise encumber the property or without such powers. The property will not be subject to 4

5 probate proceedings and will pass automatically to charity, according to the terms of the deed (and by operation of law) upon the death of the life tenant. The life tenant should remain responsible for the property taxes and maintenance on the property so that he or she can continue to take the items as deductions on his or her individual taxes. A remainder interest in a home cannot be given to charity using a charitable remainder trust if the donor wants to continue residing in the property. The rules against self-dealing would be violated by the donor s continued use of the property. The donor could transfer, irrevocably, a remainder interest in a personal residence or farm to charity, retaining the right to use the property for life or for a term certain. Using this structure, the donor would be entitled to an income tax deduction for the present value of the remainder interest (see the attached Exhibit II). The residence need not be the principle residence of the donor, but could be a vacation home. Typically, the deed delineates that the donor will maintain and improve the property, and is responsible for real estate taxes and the like. In addition, the deed should include a clause which obligates the donor to pay any estate taxes associated with the transfer to charity. Historically, this has been an attractive vehicle for both donors and charities. A donor may reserve a life estate in his personal residence or farm for his or her own life and that of a concurrent or survivor beneficiary; and may create a life estate for one or more beneficiaries, which do not include the donor. Obviously, a donor may need cash currently to live, even if he or she desires to benefit charity. A reverse mortgage (discussed below) could be attractive, but it does not fulfill the charitable desires of the donor. For the individual who wants to give a remainder interest his or her residence/farm to charity, while at the same time obtaining current cash, two alternatives are available. A first option is for the donor to sell the remainder interest to charity on a bargain sale basis, where the donor does not charge the charity the full amount of the present value of the remainder interest. Another alternative is for the donor to retain an income interest in the property, and simultaneously sell the remainder interest in the property to charity through the use of a charitable gift annuity (GCA). Under this type of arrangement, the donor and the charity will enter into a gift annuity agreement. The donor then will transfer the property to the charity reserving an income interest. The charity will pay the donor and the donor s designated beneficiaries a fixed annuity amount until the death of the last beneficiary. The donor is entitled to a charitable deduction in the year the agreement is made. The amount of the charitable deduction is the fair market value of the property, reduced by the present value of the retained income interest, reduced further by the present value of the annuity. An appraisal of the property to determine fair market value is required. Typically, the amount of the annuity is determined by rates established by the charity or by using uniform gift annuity rates recommended by the American Council on Gift Annuities. When dealing with real property, annuity rates are generally lower because of the lack of liquidity of the asset and the risks associated with owning real estate. The annuity payments can be spread over a single lifetime, two lives in succession, or joint and survivor lives as determined by the donor. The annuity payments can be immediate or deferred. A portion of each annuity payment is considered a return of the donor s principal and is tax free. A second portion of the payments may be subject to capital gains unless the difference between the donor s cost basis and the fair market value of the property at time of donation falls within exclusion amount for sale of a principal residence. The balance of the payments is interest and is taxed as ordinary income. In addition, if the property is encumbered by debt, the amount of debt is treated as an amount realized immediately by the donor pursuant to the bargain/sale rules of Code Section 1011(b) and Treas. Reg. Sec The annuity payments are made by the charity out of their general funds and become an obligation of the charity. The payments continue even if the charity no longer owns the property. If the donor decides to move from the property, the property can be sold by the donor and the charity. The donor has the option of continuing the lifetime gift annuity payments, donating the life interest outright to the charity, or donating the life interest to the charity in exchange for a second gift annuity. The prohibition against gifts of partial interests will not apply so long as the donation of the life estate was not pre-arranged. If a second gift annuity is selected, the issues regarding classification of income on the first annuity apply to the second annuity 5

6 although no portion of the payments will be tax free. It will be necessary to have the life interest appraised to determine its value. IV. Reverse Mortgages A reverse mortgage is designed to allow an individual to spend down the equity in his residence while continuing to live in the residence. An individual who is 62 years of age or older can apply for a reverse mortgage. The amount available to the individual through the reverse mortgage is based upon the amount of debt currently on the property, appraised value of the home, age of the applicant and current interest rates. Most reverse mortgages must be the first lien on the property, which means that any existing indebtedness must be paid from the proceeds of the reverse mortgage. There is no credit check or verification of income required during the application process. Once the reverse mortgage is in place, the applicant can withdraw a lump sum or a monthly advance or any combination of the two. There are no payments due, although interest accrues on the outstanding balance. The loan is paid when the house is sold, the applicant dies, or the applicant permanently moves from the property. A move is permanent if the applicant moves from the property and remains away for 12 consecutive months. In the case of death of the applicant or a permanent move, the representative of the individual is given up to one year to repay the loan. There is no escrow for property taxes or insurance. The failure of the applicant to pay these expenses will require full repayment of the loan. The interest that accrues on the loan is not deductible until the loan is repaid. An advantage to this type of mortgage is that the residence will not be lost to foreclosure. A reverse mortgage is nonrecourse, which means that the repayment is limited to the value of the home, even if the home declines in value. On the other hand, if the home s value appreciates, it is possible for the individual to apply for additional funds. Withdrawals from the loan do not affect Social Security or Medicare benefits, but loan advances could affect public benefits such as Medicaid or Social Security by being counted as a liquid asset. One disadvantage of the reverse mortgage is the high costs of the loan. Lenders charge up to 2% of the value of the loan as an origination fee, and up to 2% of the value of the loan as an insurance premium. In addition, there are the ordinary costs of settlement, such as recordation and transfer taxes. Most loans have variable rates rather than fixed rates. In order to make the loans more attractive, lenders have recently lowered the costs associated with the loans. V. Problems of A Home in Probate Real property often constitutes a large part of the probate estate. Frequently, when a real property owner passes away, the property is left vacant. Many insurance companies will not insure a vacant property and will require an owner to notify the insurance company once the property becomes vacant. Upon notification that a property owner is deceased, the insurance company often will cancel the homeowner's insurance policy. There are companies that insure vacant property but the premiums are astronomical. If the personal representative does not notify the company that the owner is deceased, and a claim arises with respect to the property, the insurance company will likely deny coverage based on the lack of notification. If the personal representative decides not to notify the insurance company about the vacancy, he or she should be careful in cancelling other insurance policies that are linked to homeowner's insurance such as automobile insurance. One way to side step the potential issue with homeowner's insurance is to permit a "caretaker" to reside in the property. This solution is not without potential problems. A personal representative has a fiduciary duty to make the assets of the estate productive or income producing. A question arises as to when the benefit of residing in the property rent-free outweighs the benefit to the estate of having someone to care for the property. An argument can arise as to whether the caretaker should pay rent and what if any, expenses should be paid by the caretaker. It is prudent to work out the details of such an arrangement and get the agreement of the beneficiaries at the outset. Maryland permits the personal representative to use the tax assessed value of real property rather than the fair market value of real property for inventory purposes. Using the assessed value of the property can save the personal representative the time of selecting a qualified appraiser and being present during the inspection and the 6

7 estate the cost of the appraisal. In most cases, however, it is wise to get a fair market appraisal especially if the property is to be sold. The value used by the personal representative for inventory purposes will be the new cost basis of the property. Since the tax assessed value is typically lower than the fair market value, there might be a large capital gain on the sale of the property. If the property will be sold by the estate, an appraisal will establish the FMV of the property for capital gains purposes as well as listing price for the property. In many cases, a beneficiary or interested person may want to purchase real property from an estate. If the property is to be sold for less than its FMV, the personal representative should seek the approval of the Orphans Court prior to the sale. Furthermore, if the property is to be sold to a beneficiary of the estate even at FMV, the personal representative should seek the approval of the Orphan s Court or the written consent of all of the beneficiaries to avoid the appearance of impropriety. A personal representative who wants to purchase property in an estate should be especially careful to avoid any breach of fiduciary duty to the estate and the beneficiaries. The personal representative has the duty to sell the estate assets for the highest price and typically has a conflict when attempting to purchase property for himself, since he will want to purchase the property for a lower value. Again, it is prudent for the personal representative to seek the approval of the Orphans Court and the consent of the beneficiaries. Real property subject to a mortgage lien can be a problem in estates with little liquidity. Death and/or the commencement of probate proceedings do not prohibit a lien holder from foreclosing on the property. An estate cannot file bankruptcy even if it is insolvent, so it is important for a personal representative to find a way to make monthly mortgage payments. In general, mortgage lenders will work with a personal representative who is actively trying to market and sell property. Other creditors with an interest in real property such as condominium associations must also be paid on a monthly basis, but will work with a personal representative who is cash-poor. A creditor who has a judgment which is recorded against the property has no rights which make it superior to other creditors and must wait to be paid. 7

8 Planning for the Home What to Do With the Old One Wednesday, March 19, :00 2:30 PM Eastern Emanuel J. Kallina, II, JD, LLM Kallina & Associates, LLC 1122 Kenilworth Drive, Suite 507 Towson, MD Presented by the National Committee on Planned Giving Qualified Personal Residence Trusts ( QPRTs ) Principle residence or vacation Only 2 residences at any one time Who uses - $4M or more gross estate Retained Interest, Gift of Remainder All rights of a Grantor Trust: Deduct interest Deduct real estate taxes Exclude $250K (or $500K if married) 1 8

9 Qualified Personal Residence Trusts ( QPRTs ) No refinancing or additional mortgages Sale: Reinvest in another residence GRAT Termination of Trust 30 day rule 2 Qualified Personal Residence Trusts ( QPRTs ) Advantages Minimal transfer taxes Freeze on value No Lose proposition Additional transfer tax possibilities Not a tax shelter! 3 9

10 Qualified Personal Residence Trusts ( QPRTs ) Disadvantages Irrevocability Death during term No step-up in basis at death No legal right to occupy after term ends Rent required after term ends Costs of the transaction 4 Qualified Personal Residence Trusts ( QPRTs ) Solutions Create/Use an ILIT as remainderman Presumably friendly trustee Rent is not taxable to kids Rent can be used to pay premiums Avoid GST by sale to Dynasty Trust 5 10

11 Qualified Personal Residence Trusts ( QPRTs ) Case Study $250, vacation home Tahoe 1977 Honey Pot FMV = $2M 2 QPRTs, deed 50% to each 25% discount FMV of 50% = $750K 6 Qualified Personal Residence Trusts ( QPRTs ) Case Study Mom & Dad = year term <$200,000 of lifetime exemption Shorter term? Sale of remainder to Dynasty Trust?????? 7 11

12 Qualified Personal Residence Trusts ( QPRTs ) Benefits No permission required (except for friendly trustee) Rent isn t being paid to kids Rent used for insurance premiums gift tax free! Honey Pot in family forever 8 The Use of Revocable Living Trusts ( RLTs ) Revocable Living Trusts Revocable Same tax and ownership rules as owning home in names of H&W: Mortgage & real estate deductions Sale, mortgage, transfer No recordation or transfer taxes 9 12

13 The Use of Revocable Living Trusts ( RLTs ) Revocable Living Trusts Co-Trustee and successor Trustee advantages No probate in state of residency No probate for out-of-state property Tenants By Entireties is probably LOST 10 Gifting Remainder Interests to Charity Life estate deed Gift of remainder in residence/farm (no CRT is available) Transfer in return for a gift annuity 11 13

14 Gifting Remainder Interests to Charity Sale of a portion of remainder interest in residence/farm Bargain/Sale Gift Annuity 12 Reverse Mortgages Age 62 or older Pay off old mortgages Lump sum and/or monthly advances Repay when home sold, owner dies, owner permanently moves Loan is non-recourse 13 14

15 Reverse Mortgages Disadvantages: Origination fee - 2% Insurance Premium fee 2% Recordation & other costs Variable rate, not fixed 14 Problems of a Home in Probate Insurance & vacancies No insurance or high cost if vacant Denial of coverage risks Caretaker option Pay? Free rent? Expenses paid by caretaker? PR? 15 15

16 Problems of a Home in Probate Appraisals Assessed value versus FMV Issue regarding step-up in basis Fiduciary Issues Sale for less than FMV Sale to beneficiary Sale to PR 16 Problems of a Home in Probate Foreclosure Liquidity issues Death & probate don t stop lenders 17 16

17 Conclusion and Q&A To ask a question: Press *1 on your touch-tone phone (Please note that *1 will not work if you are using a speaker phone pick up the hand set before selecting *1.) -or - Type your question into the box in the lower right corner of your screen and click Send 18 Thank you for participating! For more information, contact: Emanuel J. Kallina, II, JD, LLM Kallina & Associates, LLC 1122 Kenilworth Drive, Suite 507 Towson, MD