A qualified personal residence trust can be useful when you are exposed to federal transfer taxes. There is a federal estate tax, and there is also a federal gift tax. These taxes are said to be unified by the Internal Revenue Service.
Unification of Gift and Estate Tax
When the estate tax was first enacted in 1916, there was no federal gift tax. As a result, people could just give gifts while they were living to avoid the estate tax. To close this loophole, a gift tax was put into place in 1924. It was repealed in 1926, but it was reenacted in 1932. It was unified with the estate tax in 1976.
The maximum rate stands at 40 percent at the present time.
There is a federal transfer tax credit or exclusion. You would not be exposed to taxation if your assets do not exceed the amount of the exclusion. In 2014, the unified lifetime exclusion is $5.34 million.
Qualified Personal Residence Trusts
Now that we have provided the necessary background information, we can look at qualified personal residence trusts. If you determine that you are going to be exposed to transfer taxes, you could place your residence into a qualified personal residence trust.
When you implement this strategy, your day-to-day life does not change right away. You draw up a trust agreement and you decide on a term during which you will remain in the home as usual. This is referred to as the retained income period.
You also name a beneficiary in the trust agreement. This individual will inherit the property after the term expires.
Because a beneficiary is going to assume ownership of the property eventually, the act of funding the qualified personal residence trust with the home is considered to be an act of taxable gift giving by the Internal Revenue Service. However, the taxable value of the gift is going to be far less than the fair market value of the home.
This is because of the retained income period. If you were going to sell your home to someone under the stipulation that the buyer could not assume ownership for 10 or 15 years, the buyer would not pay full fair market value. The IRS takes this into consideration when they are determining the taxable value of the gift.
When the term expires, the beneficiary assumes ownership of the home, and significant tax savings will be realized.
A longer trust term would result in more tax savings. However, the strategy fails if you pass away before the term has expired. Under these circumstances, the home would once again become part of your taxable estate. This is something to take into consideration when you are deciding on the duration of the trust term.
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If you would like to learn more about qualified personal residence trusts and other legal devices that can yield tax efficiency, contact us to schedule a free consultation.