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Friday, February 20, 2009

Perfect Time to do Estate Planning for that Vacation Home

Sometimes in a bad economy, opportunities present themselves. One great planning opportunity that currently makes a lot of sense is a special trust known as a QPRT (Qualified Personal Residence Trust). A QPRT is great way to pass on wealth to your heirs in a tax efficient manner and without affecting your more liquid assets.

Here's generally how it works:
1) The owner of a property places a personal residence (or vacation home) in trust. The owner can continue to live in and use the property for a set number of years. At the end of the term, the property goes to whomever the owner wants, typically the owner's child or into another trust for the benefit of the child.
2) This gift is a legally enforceable promise to make a gift of the property to the child in X years from now. So, if the house is worth $500,000, and you promise to give it to your daughter 7 years from now, it is not really a $500,000 gift due to the time/value of money. The actual amount of the gift depends upon a variety of factors including the age of the donor and the current interest rate.
3) This plan can produce large estate tax savings. Giving away property while you are alive is an estate planning tax strategy known as an estate freeze. You are giving away property now so that future growth occurs in the estate of your heirs, rather than in your own estate. A QPRT leverages this strategy so that you are combining a discounted gift with an estate freeze.
  • Assume the following hypothetical. A wealthy 70 year old woman (worth $3,500,000) lives in New Jersey and has one adult son. She owns a shore home worth $1,000,000. Now, upon this woman's death, in New Jersey, she may bequeath $675,000 before having a NJ estate tax. Under current federal law, she can bequeath $3,500,000 before she has a federal estate tax. There is no limit to what she may gift away during life according to NJ, but the federal limit is $1,000,000. After that, there is a federal gift tax.
  • This woman decides to give away her shore home, worth $1,000,000, to her daughter. She structures the transaction so that the term of the QPRT is 7 years. This results in a taxable gift for federal gift tax purposes of $657,300 based upon the woman's age, the term of the trust and the March 2009 Section 7520 rate. There is no NJ gift tax.
  • Now, let's fast forward 7 years and 1 day, when the woman passes. I will assume the value of the shore property increased to about $1,300,000 and the rest of her estate only modestly increased from $2.5 Million to $2,700,000. If she had not given anything away, then at the time of her death her estate would have equaled $4,000,000. Assuming that the federal estate tax exemption remains at $3,500,000 and the New Jersey Estate tax exemption remains at $675,000, then her estate would have a combined estate tax liability of approximately $505,400 ($225,000 federal and $280,400 New Jersey). By making this gift via a QPRT, we completely elimiate the federal estate tax and the New Jersey estate tax would be reduced to approximately $155,600 - a savings of $349,800. (To compare with an outright gift of property, the combined estate tax would be $245,600, a savings of only $259,800.)
Traps to be wary of:
1) Be careful about giving away highly appreciated real estate unless you are quite sure the donees plan to keep it in the family for a long time. This is because the donees receive the gift with a carryover basis and could be subject to a very large capital gains tax upon the sale of the property.
2) Do not use this technique if the donor is in poor health. Setting up a QPRT is most effective when the donor survives the term of the trust. If the donor does not survive, then the property is included in his gross estate for both federal and state estate tax purposes.
3) For the same reason as Trap #2, it is best not to set up too long of a term. The longer the term, the greater the risk that the donor will pass. In my opinion, a term longer than 10 years usually produces a risk that outweighs the benefits of obtaining a discount on the gift. This is especially true now that the federal estate tax exemption has increased.
4) If the donor is married, it is usually best to set up two QPRTs, with the wife giving away her half in one QPRT and the husband giving away his half in the other. This technique increases the chance that at least one person will survive the term.
5) This technique works even better when there is a high interest rate, so if the owner has an estate subject to the federal estate tax, the best time to do a QPRT is when the value of the property value is low, but the AFR (applicable federal rate) is high.

In conclusion, this is still a great time to do gift planning, but you should consider doing so with assets that are not as liquid.

Note: QPRT calculations done courtesy of Adam Epstein at Bernstein Wealth Management.

Wednesday, February 11, 2009

Beware the Compromise Tax

One area of estate administration that often gets overlooked on tax returns is the compromise tax. When a decedent transfers assets that are subject to a contingency or are otherwise difficult to value, the taxing jurisdiction and the estate must compromise on the tax due.

There are a variety of reasons an asset may be difficult to value, but the most common reason is because the asset is subject to a lawsuit. For example, if Decedent died owning a 60% interest in a closely held company, it is relatively easy to determine the value (although people may disagree as to the true value). If however, Decedent's surviving business partner claimed that Decedent really only owned 20% and that Decedent "cooked the books", Decedent's estate will be very difficult to determine until the matter of Decedent's true ownership is resolved. The government, however, wants its money now. This is one area in which the estate and the taxing authority can compromise on the tax due. Oftentimes, this type of situation is difficult to avoid even with great planning.

As for transferring assets subject to a contingency, this is something that can be planned for. Let's say there is a man who wants to leave money in trust for his wife, or Civil Union Partner, and then when the wife or Civil Union Partner dies, the money will go to the man's brother. In a states like New Jersey and Pennsylvania, the transfer to the brother would give rise to an inheritance tax of about 15%. So the question then becomes how do we value the likelihood that the brother will receive the money. In essence, we will have to use life expectancy measurements for the surviving wife or Civil Union Partner to determine that person's interest, and then we can determine the remainder interest. This can get very complex depending upon what, if any, rights to principal the survivor has - hence, a compromise tax.

So when does all this knowledge become really important? When filing the tax return, if the proper amount of taxes are not remitted, then large interest and penalties will be due.

New Jersey Estate Administration Update

I just got back from an interesting lecture sponsored by the Mercer County Estate Planning Council. The keynote speaker was a representative from the New Jersey Department of Inheritance and Estate Taxation. Unfortunately I can't remember his name, but he mentioned a few things that I thought were important enough to highlight and share.

It turns out that approximately 50% of all estate and inheritance returns that get filed are audited. They are especially aggressive in auditing returns in which the decedent owned a business, if there are valuation discounts claimed, if a compromise tax is made, or if the numbers just don't add up. (Note: For more on the compromise tax, please see: Beware the compromise tax.)

The other noteworthy item the representative mentioned that they are more aggressively going after estates where no tax return is filed. They receive information about taxable estates from insurance companies who pay out death benefits and from the Surrogate when wills are probated.

Monday, February 9, 2009

Gifting to US residents - who pays the gift tax?

I am frequently asked some variation of this question: "My father is a citizen of country X, and wants to make a gift to me. Is there any tax?"

I then get to give a lawyer's favorite answer. It depends.

It depends:

  1. Where is the person making the gift (the "Donor") domiciled?
  2. What is the citizenship of the donor?
  3. Is the donor a permanent resident alien of the US?
  4. Where is the person receiving the gift (the "Donee") domiciled?
  5. What is the citizenship of the donee?
  6. How much is being transferred?
  7. Is it being transferred all at once, or over time?
  • Is it real estate, stock or some other type of property?
  • If it is real estate or stock, where is it located?
  • As a general rule: If the donor is a US citizen or a permanent resident alien, then the gift is subject to US tax laws. It will then be considered a taxable gift if it exceeds the annual exclusion amount. As of 2009, this is $13,000. If the donor is neither a US citizen nor a permanent resident alien, and the gift is being made from assets outside of the US, then US tax law will not apply. In such a case, we must look to the citizenship and domicile of the donor and donee plus we must look where the property is located to determine which tax law applies.

    There is a special rule for real estate and stock. This is a three step process:
    1. If the real estate or stock is located in America, it is subject to US gift tax regardless of where the donor or donee live.
    2. If the real estate or stock is not located in America, we must then determine the whether there is a gift tax treaty with the country where the property is located and the Donor and/or the Donee. If there is a treaty, gifts of real property are usually governed by the law of the country where the property is located, regardless of the citizenship of the donor or donee.
    3. However, if the property is located outside of the US, and there is no treaty, or if the treaty is silent regarding taxing rights, then it gets to be much trickier and no rule can suffice. A knowledgeable attorney and tax adviser must look at the laws relevant to the donors, donees and property to determine which country's tax laws apply. Keep in mind, more than one country might have the right to tax this transaction.
    For example, let's say a Japanese national wishes to make a cash gift ¥11,100,000 (or about $110,000) to her daughter who lives in America, then Japan has a right to tax this gift. Under Japanese law, a person receiving the property (the donee) will be taxed on the transfer. (Note: I am assuming the daughter is still a Japanese citizen) A gift of this amount would be entitled to a tax exemption of ¥1,100,000 and the remaining ¥10,000,000 would be subject to a tax of ¥2,750,000 (or about $27,000).

    Another example would be where a citizen of India makes a gift of US real estate to their child in America. Since the property is in the US, and there is no gift tax treaty between the US and India, the United States has the sole right to tax this gift. If the house was worth $263,000, then $13,000 of the gift would be tax free. The remaining $250,000 will be subject to a US gift tax of over $70,000. See Section 2511 of the Internal Revenue Code. (In this case, although a donor is normally responsible for the tax, the donee will become responsible as the US does not have the right to collect from a citizen of India. However, if the donee does pay the tax, it will be considered another taxable gift.)

    The bigger the gift, the harder it is to completely eliminate the tax. However, regardless of which country has the legal authority to tax the gift, most gifts can be structured in ways to reduce or eliminate the taxes with proper planning.

    Gift planning can be especially valuable if the donor is over the estate or inheritance tax threshold in the United States or the donor's home country. By making planned gifts, this reduces the overall tax and could save anywhere from 5 cents on the dollar to 55 cents on the dollar.

    Most of the planning can be done with little cost or no cost. Feel free to contact us if you would like more information.