Accounting: How to give away your home tax free

You can give away up to $5,120,000 for the rest of this year without paying gift tax. If this higher federal gift tax exemption is not used, and the exemption falls back to $1 million in 2013, then this important opportunity will have been lost.
Making a gift this year is particularly attractive to Washingtonians, because while there is no gift tax in Washington, there is an estate tax on assets over $2 million. Accordingly, anything that is given away prior to death avoids the Washington estate tax. The current combined federal and Washington estate tax rate is 47.35 percent. Next year, the federal estate tax rate is scheduled to increase to 55 percent.
For Washingtonians whose estate may be subject to federal or Washington state estate tax, the tough question is, what do I give away? As Americans are living longer, it may be difficult to give away cash and other investment assets that could be needed down the road.
But what if you could give something away, yet retain the right to use the asset for as long as you specify? While this is not generally permitted by tax law, an exception is a gift of a home to a Qualified Personal Residence Trust (QPRT).
The tax regulations are somewhat complex, but the basic idea of a QPRT is straightforward. An individual or couple may give away a primary or secondary residence to a QPRT, and retain the right to live in the residence for the term of the trust, which is a specified number of years.
When the term ends, the beneficiaries (such as children or a trust for children) receive the home without any further gift tax, and the value of the home is excluded from the donor’s taxable estate. Even better, for federal gift tax purposes, the value of the gift is reduced by the value of the right to continue to live in the residence.
The mechanics of a QPRT may be illustrated by the following example: If an individual who is age 70 gives a $10 million home to a QPRT and retains a right to live in the residence until age 85, the gift tax value is only about $3.8 million, well within the federal gift tax exemption.
If the donor outlives the term of the trust, then the entire $10 million home, plus 15 years’ worth of appreciation, will pass to the beneficiaries without estate tax. Assuming the tax laws change as planned, the estate tax savings is $7.7 million, not including estate tax saved on the appreciation. Even if the exemption remains at today’s higher level, at least $2.9 million of estate tax would be saved.
There is a catch. The tax benefit is lost if the donor dies during the term of the trust. In that case, the home is included in the donor’s taxable estate, just as if the QPRT had never been established. On the other hand, the donor is no worse off.
This means that the term of the trust should be as long as possible, but shorter than the donor’s life expectancy. A married couple can actually choose two different terms. For example, one spouse could choose a 10-year term and the other could choose a 15-year term, which would make sense if differences in age or family history suggest each had a different life expectancy. If one spouse survives the respective term, but the other does not, then the couple receives about half of the tax benefit.
It is important to remember that at the end of the term, the beneficiaries will own the residence, which may be another reason the term should be as long as possible. If there is no agreement at the time the QPRT is established, the donors can rent the residence back from the beneficiaries at the end of the term. This not only gives the beneficiaries a source of funds to pay property taxes and insurance, but each rental payment serves as yet another avenue to transfer wealth to the next generation.
While a QPRT may provide a significant estate tax benefit, as with all gifts made during life, the beneficiaries receive the donor’s tax basis in the residence. If the QPRT had not been established, and the donors died owning the residence, then the residence would receive a stepped-up tax basis at death, allowing the beneficiaries to then sell the property without capital gains tax.
However, for those who may be subject to federal estate tax, the tax savings of using a QPRT are likely to outweigh the lost income tax benefit, even if the capital gains rate increases.
If you are considering a QPRT, an attorney can help you navigate the other issues, which include the options that are available if the donors sell their home during the term (including the purchase of a replacement residence in the QPRT), and how best to establish a QPRT if the home has a mortgage.
A QPRT is an attractive option for anyone who owns their own home and would like to make a gift in 2012 while the gift tax exemption remains at a historically high level.
While there are some tradeoffs and important considerations, a QPRT is a relatively low-risk way to achieve the tax benefits of giving away your home, while retaining the right to live in it for many years.
WALTER IMPERT is a partner in Dorsey & Whitney’s Tax, Trusts and Estates Practice Group in Seattle, where he can be reached at 206.903.2439. JAY RIFFKIN is an associate in Dorsey & Whitney’s Tax, Trusts and Estates Practice Group in Seattle, and can be reached at 206.903.8706.