The goal of “leverage” is to use as little as your exemption NOW to remove the maximum assets possible from the reach of the estate tax. You get the best bang for your buck by removing assets like real estate, which historically continue to increase in value over time. Making gifts of real estate now, particularly through a tax-advantaged vehicle, is a great way to make maximum use of your exemption. Following is an illustration showing how creating a qualified personal residence trust (QPRT) for a primary or secondary residence achieves optimal leverage of your exemption:
Let’s say you own a home valued at $1million. If you transfer it to a QPRT, and outlive the trust term, it is out of your estate and so is any appreciation on the property. Plus, the property’s value at the time of the gift is discounted below actual market value, because of special tax rules that factor in the likelihood that you, the owner, will outlive the trust term.
If you transfer your million dollar home to a QPRT, and it is valued at $750,000 because of the discount factors, the asset is out of your estate if you survive the trust term. The tax cost at the time the QPRT is established is $262,500 ($750,000 x 35%.) If you have exemption amount remaining to cover this, no cash will be needed to pay the gift tax. If a cash payment is required, there’s still a tremendous upside:
• You retain the right to live in the house and can lease it thereafter under special tax rules.
• If at the time of your death the home has appreciated in value to $2 million, using today’s 35% rates you will have saved at least $437,500 in tax dollars ($350,000 on the appreciation from $1 to $2 million in value, plus $87,500 on the discounted value ($750,000 and not $1million valuation when the gift is made.) The savings are even greater if the tax rates go up to 55%
• If no QPRT is created and the home remains an asset in the estate, at death it will be subject to $700,000 in estate tax (using today’s low rates 35% rates) or $1.1 million in taxes if the rate goes up to 55% as planned post-2012. Devices like QPRTs often have other advantages, apart from tax savings. For example, a QPRT can facilitate passing a cherished vacation home to the next generation. It provides an opportunity for keeping legacy properties in the family and thereby eliminating the risk that heirs may be forced to sell a cherished asset to pay the tax bill.
Using Discounts to Create Tax Savings
If you own a property worth $5 million, and divide it into smaller parts – among e.g. children and grandchildren, you have an opportunity to create a discount to the extent you hold a “minority” interest which lacks control. Creating a family limited partnership to hold an operating business or family investment assets illustrates the tax savings this creates. Let’s say Dad has spent a lifetime building a family business now worth $5 million.
He wants it to eventually go to children who work in the business as well as provide an income stream to other children, or even grandchildren who will have no part in running the business. A family limited partnership is a unique legal entity that enables different ownership interests to be created, so that shares with management say or voting rights can be “gifted” to some heirs, while others can be given non-voting interests that participate only in certain cash streams.
Once the family limited partnership is formed, Dad can gradually gift or sell limited partnership interests to his heirs and retain an interest as well. If Dad gives away 60% of the business, which can be done in part through annual tax exempt gifts of $13,000 to each child or grandchild, he will retain a minority 40% interest. For tax purposes, his retained interest is not valued at $2 million ($5 million x 40%). Instead his interest will be discounted for lack of marketability and control. This discount could be in the neighborhood of 30% depending on a variety of factors. Assuming it’s valued at $1.4 million for tax purposes, here’s what happens:
• Even if the business hasn’t appreciated when Dad passes away, by giving away his interest through a family limited partnership, his estate tax savings are $210,000: ($1.4 million x 35% tax rate = $490,000) vs. ($2.0 million (40% ownership at fair market value) x 35 tax rate ($700,000).
• Not only will 60% of the business be out of the estate, but the appreciation on the amount gifted away is also out of the estate, thus avoiding estate tax.
• If the tax rate goes up to 55% by the time of his death, his tax savings are even greater. If he retained full ownership in the business and it hadn’t appreciated, taxes of $2,750,000 would be due. If he dies owning 40% interest valued at $1.4 million, his tax bill at a 55% tax rate is $770,000. There’s still a savings of over $2 million in taxes.