Planning Idea With New $5 Million Gift Tax Exemption

This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. | Washington Business Journal

The tax bill enacted at the end of 2010 provides a $5 million exemption from federal gift tax for aggregate lifetime gifts ($10 million for a married couple). This exemption applies for 2011 and 2012, and is in addition to the $13,000 annual exclusion gifts that may be made free of federal gift tax every year.

This increase in exemption from the prior $1 million limit for lifetime gifts allows wealthy taxpayers to consider strategies such as the creation of a Qualified Personal Residence Trust (QPRT) for a valuable first or second home.

Briefly, a QPRT works as follows:

  • A residence is transferred to a trust that provides the transferor with exclusive use of the residence for a term of years; at the end of the term, the residence is transferred to or for the benefit of others (usually children). The transferor would then pay rent to the children if he or she continues living in the residence.
  •  The gift is equal to the excess of the value of the residence over the value of what the transferor has retained (i.e., the right to use the residence for a number of years). The value of the transferor’s retained interest is determined based upon annuity factors published each month by the IRS and is dependent upon the transferor’s age, the trust term and current interest rates.
  • If the transferor dies during the trust term, then the entire value of the residence is included in his/her estate Thus, while a longer term reduces the value of the gift, it increases the chances that the QPRT strategy will not work. This is one of the factors that made the QPRT strategy less attractive to older taxpayers when the gift tax exemption was only $1 million – a shorter life expectancy made it more difficult to set the term long enough to keep the gift value below the exemption limit.

To illustrate, an 80-year-old who this month transfers a $2 million home to a QPRT with a three-year term would be making a taxable gift of $1,483,160. At the end of the three-year term, the residence would belong to the children. If the residence had increased in value 3 percent annually, the children would receive an asset worth $2,185,454 in exchange for the parent’s use of only $1,483,160 of exemption. Assuming the transferor’s total estate at his or her later death exceeds the estate tax exemption, the additional $702,294 of value that was transferred would save $245,803 in federal estate tax at a 35 percent rate (or $316,032 if the rate reverts to 45 percent; $386,262 if the 55 percent rate that is now on the books for 2013 and later years applies).

Note, however, the children’s basis in the residence will be the same as the parent’s basis at the time of gift. There will not be a step-up in basis as there would be if the property had been included in the parent’s estate. For this reason, a QPRT is often most attractive for property that will stay in the family after the parent’s death.

Many specific rules apply to QPRTs. You should consult your legal and tax advisors to determine if a QPRT is appropriate in your personal situation.


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