IN THIS ISSUE:
Feature Article:
The Qualified Personal Residence Trust
RECENT DEVELOPMENTS:
The Qualified Personal Residence Trust
ormally, the federal estate tax applies to the value of assets in your estate, measured at the date of death. If you give something away during your lifetime, the gift tax kicks in; the tax is based on the fair market value at the time of the gift. But there is an exception that applies to a gift of your personal residence. A transfer of a personal residence is taxed at only a fraction of its fair market value, if it is made to a special type of trust called a Qualified Personal Residence Trust (QPRT). Intelligent use of this type of trust can result in substantial estate tax savings.
How it Works
To create a Qualified Personal Residence Trust, you transfer a primary residence or a secondary residence such as a vacation home to an irrevocable trust. The trust provides that you are entitled to continue to live in the home rent-free during the existence of the trust. After a specified period of time (for example, ten years), the trust ends and ownership of the residence is transferred to your children or other beneficiaries.
To obtain a tax benefit, you must survive at least as long as the trust. If you do, the house will not be part of your estate for estate tax purposes. More importantly, for gift tax purposes, you've made a gift of only a portion of the value of the home. And if the home increases in value, all of the increase escapes estate and gift tax.
An Illustration
Alice, a 55 year old widow, places her $300,000 home into a QPRT that will last for a term of 15 years. During those 15 years, Alice continues to live in the home and pay the taxes and other expenses of upkeep. When the trust ends, the property will pass to her children.
Tax Consequences
Under actuarial tables published by the IRS, Alice has made a gift for gift tax purposes in the amount of $71,058. This amount is well within the $600,000 estate and gift tax exemption, so she is not required to pay gift tax on creation of the trust. If Alice survives to at least age 70, the property will not be included in her estate. The balance of her $600,000 exemption is available to offset estate tax on other property that she owns at the time of her death.
If Alice had kept the home in her name, the full value would have been subject to tax in her estate at the rate of at least 37%. If she had given it outright to her children, she would have used up $300,000 of her $600,000 lifetime estate and gift tax exemption. By creating the trust, she has removed the home from her estate and has made a gift of only about $71,000. Assuming she is in the 50% estate tax bracket and the house grows in value at the rate of 5% to her life expectancy, the amount of tax saved is about $275,000.
What happens if Alice does not outlive the trust? According to actuarial tables published by the United States Government, Alice's life expectancy at age 55 is about 23 years. However, if she dies within the 15 year term of the trust, the effect will be approximately the same as if she had never created the trust. The home will be included in her estate at its date of death value, and the gift she made by creating the trust will not be taxed.
When you create a QPRT, you can decide how long you want the trust to last. If you choose a longer term, the potential tax savings will be greater. That's because for tax purposes, you are treated as making a smaller gift when the trust term is longer. The graph below shows the relationship between the term of the trust and the gift tax treatment. Ideally, you want to choose a term that you are confident you will survive, but that will produce substantial tax savings.
Sale of the HomeWhat if Alice wants to sell the home before the trust has ended? As trustee of the trust, she can do so. And she can decide whether or not to reinvest the proceeds in another home. She is entitled to the same income tax benefits that would apply if she sold the home outside of the trust, including the $125,000 one-time capital gain exclusion.
After the Trust
Where does Alice go after the trust has ended? The residence is now owned by the children. Is she required to move out of the home? Not necessarily. There are a number of planning options available to her. One alternative is for her to lease the home from the trust, or from her children. The rental payments that she makes will further reduce the size of her estate for tax purposes.
Capital Gains: A New Wrinkle
Let's assume Alice purchased the home many years ago, for only $100,000. There is a potential taxable capital gain on sale of the property. When the trust ends, that potential income tax liability is transferred to Alice's children, because they take over her income tax basis. If they sell the home after receiving it from the trust, they will pay income tax on the $200,000 capital gain. This potential income tax liability is a disadvantage of using a QPRT.
Until recently, a purchase of the home from the trust was a solution to this problem. The plan: Alice buys the residence back just before the trust is scheduled to end. She keeps the home for the rest of her life, and gives it to the children by will. The potential capital gains tax is removed at Alice's death because the income tax basis is "stepped up" to the property's fair market value.
In May of this year, the IRS threw a wet blanket on this type of planning. It issued proposed regulations providing that a trust does not qualify as a QPRT unless it explicitly prohibits the trust from selling the home back to the grantor or to a related party. Recent headlines have suggested that the new regulations will spell the demise of the Qualified Personal Residence Trust . See, e.g., Weitberg, "Proposed IRS Regulations Could Quash QPRTs," 144 N.J. L. J. 803 (May 27, 1996).
On the contrary, the QPRT will remain a valuable and effective estate planning technique, even if the proposed regulations are enacted in their current form. The adverse income tax effect of a gift, whether in trust or outright, should always be taken into account. But in many cases, the estate and gift tax benefits far outweigh the income tax negatives. This is true for several reasons. For one, the highest capital gains tax rate is 28%, and this may be lowered by future legislation. The estate tax, on the other hand, takes a larger bite. Estate tax marginal rates range from 37% to 55%.
Also, the income tax is payable only when (and if) the residence is sold. QPRTs are often used for vacation homes and other properties that will remain in the family over several generations.
Final thoughts
The ability to use a QPRT to save taxes is not an obscure "loophole". Congress created it intentionally by writing specific provisions into the 1990 tax law, and the Treasury Department has written pages of regulations on how to implement it. Why did Congress create preferential gift tax treatment for the personal residence? For the same reason that the tax law permits an income tax deduction for home mortgage interest, but not for other personal interest. There are millions and millions of homeowners in America. And they vote.
Further reading
IRS Proposed Regulations Concerning QPRTs (PS-4-96)
RECENT DEVELOPMENTS
Pension Benefits Payable to Ex-Wife Despite Divorce
In Re Estate of Lanken, ___ NJ. Super. ___ (Ch. Div. Probate Part 2/9/96)Peter Lanken and Rachel Lanken were divorced in 1979. In the judgment of divorce, Rachel did not ask for support, equitable distribution, or attorney fees.
Shortly after the divorce, Peter left his employment with General Electric Corporation. However, he did not notify General Electric of his divorce, and he made no change to the designation of beneficiary for his pension benefits. He had designated Rachel as the beneficiary in 1978.
After Peter's death in 1993, the battle for Peter's pension benefits began. Rachel pointed out that she was the named beneficiary at the time of death. Peter's estate countered by citing a 1991 New Jersey Supreme Court decision involving the payment of life insurance proceeds after a divorce. In that case, Vasconi v. Guardian Life Insurance Co., the Court held that a divorce and general property settlement agreement revoked the former spouse's interest in life insurance proceeds.
The court ruled in favor of Rachel. It held that the payment of the pension benefits was governed by federal law, which barred the transfer of benefits. The court found that the waiver by Rachel of support and equitable distribution did not give up her rights as beneficiary of the pension plan. Finally, the court held that the Vasconi case did not apply, since it involved life insurance, and not a pension plan.
Comment: Under New Jersey law, a divorce automatically revokes a bequest to the former spouse in a will. But, as this case illustrates, significant benefits may be left payable to the former spouse through inadvertence. After a divorce, both spouses should review and update all aspects of the estate plan, including the will and all beneficiary designations.
Newark District Enjoys Low Audit Rate
GAO/GGD-96-91 (4/26/96)The percentage of individual income tax returns audited by the IRS varies widely by geographic location, according to a recent study by the U.S. General Accounting Office (GAO). Returns filed in the Newark, New Jersey District have historically been among the least likely to be audited. Newark appears in fourth position on the GAO's list of IRS districts with the lowest individual audit rates between 1988 and 1995. The audit rate for 1995 in Newark was .39%, according to the report.
Audit rates in 1995 tended to be higher in the western regions of the country and lowest in the central states, according to the GAO. This is consistent with special audit results showing the lowest levels of voluntary compliance in the West and Southwest.
The full text of the GAO report can be found at the U.S. Government Printing Office Public Access Site.
Lottery Prizes Create Estate Tax Liquidity Problems
TAM 9616004Lottery jackpots are usually paid to the winner over an extended period of time, such as 20 years. If the winner dies before the payout is complete, federal estate tax is payable on the entire prize; even the cash not yet received. This can create a severe liquidity problem. The amount of the tax is often far greater than the cash on hand to pay it.
In TAM 9616004, the IRS explained the procedure for calculating the taxable value of a lottery prize. The present value of the right to all future payments is calculated using an IRS discount rate that changes monthly. For example, the value of a $1 million lottery prize payable over 20 years, using June's discount rate of 8%, is about $ 491,000. The IRS rejected the taxpayer's claim that the value should be further discounted because state law prohibits transfer of the lottery prize.
The estate of a New Jersey lottery winner faced a liquidity crisis involving his casino jackpot. Frederick Delnero won a $3.9 million "Megabucks" prize at a New Jersey casino in 1992. He died nine months later, having received only one of 20 installments. The estate asked permission to borrow from his future winnings the amount needed to complete payment of the $510,000 federal and New Jersey estate tax bill. The Casino Control Commission, in early April, decided to permit the loan. It will be paid back from future installment payments.
Completion of New Residence Is Too Late For Rollover
Skorniak v. Commissioner, T.C. Memo 1996-178 (April 11, 1996)Mr. and Mrs. Skorniak sold their home in California on January 31, 1992. Shortly thereafter, they bought a vacant lot in Oregon and began construction of a new home. In the meanwhile, they lived in a nearby residence in Oregon that they had purchased as a rental property.
The Skorniaks intended to avoid paying income tax on the $214,000 capital gain on sale of the California home by using the "rollover" rule of Internal Revenue Code Section 1034. Under that section, no tax is due if, within two years of the sale, you reinvest the entire net sales price of the old home in a new principal residence. But that section requires that the new home must be "purchased and used by the taxpayer as his principal residence" within the two-year period.
When the two-year deadline arrived on January 31, 1992, the new home was nearly complete. But some work was unfinished, including the sheetrocking and taping of some interior walls, and the installation of flooring. The Court concluded that the Skorniaks did not actually occupy the new residence until after January 31, 1992. Of "paramount importance" to the Court was Mr. Skorniak's admission to an IRS agent that they had not moved into the new residence until May or June of 1992.
Sale of Home to Corporation Qualifies For Rollover
PLR 9625035In another case involving rollover of capital gain, the IRS approved some clever tax planning. The taxpayer purchased a new residence before selling his old one. The gain on sale of the former home qualifies for the rollover as long as the sale occurs within 2 years after the purchase of the replacement residence. Because of a depressed real estate market, the taxpayer feared that the house would not be sold within the 2 year period. He plans to sell the home for its market value to a corporation solely owned by him. The IRS, in a private ruling, held that this sale will qualify for rollover treatment under Internal Revenue Code Section 1034.
Golf Expenses Incurred in Hobby, Not Business
Courville v. Commissioner, T.C. Memo 1996-134 (March 18, 1996)When William Courville was laid off from his employment as an optical engineer in 1991, he decided to pursue his lifelong dream of becoming a professional golfer. He attempted to qualify for events on the PGA Seniors Tour, both through a qualifying school and by entering individual tournaments. He failed to qualify in any tournament; his best result was being named as an alternate.
On his 1991 income tax return, Courville reported deductions of $16,384 from his golfing activities. The IRS challenged those deductions under Internal Revenue Code section 183, which denies deductions for any activity that is not engaged in for a profit. The test, according to prior court decisions, is whether the taxpayer has an "actual and honest objective" of making money. The Court acknowledged that the profit expectation need not be a reasonable one, as long as it is held in good faith. Nevertheless, the Tax Court sided with the IRS and denied the deductions. After reviewing all the facts, the Court was convinced that Courville's motive was more pleasure than profit.
Comment: The Court's opinion lists nine factors to be analyzed in determining the true intent of the taxpayer in this type of case. Those factors are:
the manner in which the taxpayer carries on the activity
the expertise of the taxpayer or his advisers
the time and effort expended by the taxpayer in carrying on the activity
the expectation that the assets used in the activity may appreciate in value
the success of the taxpayer in carrying on other similar or dissimilar activities
the taxpayer's history of income or losses with respect to the activity
the amount of occasional profits, if any
the financial status of the taxpayer; and
the elements of personal pleasure or recreation involved in the activity.
Sales Tax on Yellow Pages Ads Repealed
P.L. 1995, Chapter 184The New Jersey sales and use tax no longer applies to the sale of advertising in the "Yellow Pages" or similar directories provided to telecommunications customers. The change was effective April 1 of this year. However, sales of space in directories distributed prior to that date remains taxable, regardless of when the charges are paid.
Ruling Highlights Quirk in Sales Tax on Computer Data
New Jersey State Tax News, Vol. 25, No. 2 (Summer 1996), p. 16The New Jersey Division of Taxation has issued a private ruling to a company that sells databases for use in commercial activities. According to the ruling, the sale of computer data in a tangible form, such as on CD-ROM or magnetic tape, is subject to the 6% New Jersey sales tax. However, the sales tax applies only to the sale of "tangible personal property." If data is delivered electronically, such as over the Internet, nothing tangible is transferred to the customer. Therefore, the transaction is not taxable, according to the ruling.
Comment: One might question the soundness of the Division's ruling. When a customer buys a database on CD-ROM or tape, the product purchased is information. It is intangible. Only the package (the disk or tape) is tangible personal property. Nevertheless, the entire transaction is taxed, according to the ruling.
Planning tip: Assuming the ruling is correct, you can dictate the sales tax result by changing the form of delivery. The tax can be completely avoided by arranging for delivery of the data over the Internet or a private network connection. The customer can then store the information in whatever form it chooses. The end result is the same, but the tax is saved. This may be worthwhile for substantial or continuing purchases.
Real Estate Acquired Before 1977 Gets Favorable Income Tax Treatment
Patten v. U.S., Dist. Ct. W.D. Va. (April 12, 1996)People planning their estates often look for ways to reduce the size of the estate for tax purposes. But sometimes you can benefit by having more property included in your estate. That's because for income tax purposes, an asset included in the estate receives a new tax basis: its fair market value at the date of death. If the value has increased over the acquisition cost, this "step-up" in basis means that no one ever pays capital gains tax on the increase.
David Blaney was the sole owner of a parcel of real estate. On December 24, 1955 he transferred a one-half interest to his wife, Marjory. From then on, they owned the property as tenants by the entirety, the most common form of joint ownership between spouses. When David died in 1989, the property 's value had increased to $500,000. His interest passed to Marjory by right of survivorship, and she sold the property the following year.
The issue: what was Marjory's income tax basis in the real estate when she sold it? The IRS (and Marjory initially) took the position that fifty percent of the value of the property was included in David's estate. Thus, according to the IRS, the income tax basis was "stepped up" only as to that half. That resulted in a capital gain of almost $200,000. After Marjory's death, her estate argued that, because of a technicality in the effective date of the 1976 and 1981 tax laws, 100% of the property was included in David's estate. This didn't increase the estate tax on his estate because of the marital deduction available for transfers to a surviving spouse. But with a "step up" in basis on the entire property, there was no taxable capital gain on the 1990 sale.
The Court agreed with the estate; no tax was payable. In doing so, the Court followed a 1992 Court of Appeals ruling in the case of Gallenstein v. U.S.
Comment: This case highlights the potential for favorable tax treatment where the following factors are present:
Real estate jointly owned by a husband and wife was acquired before 1977
One of the spouses dies before the property is sold
The deceased spouse provided most or all of the funds to acquire the real estate.
IN MEMORY OF A FULL LIFE
According to a Japanese folk tale, a man began to worry about the prospect of death, and set out in search of the secret of immortality. After many adventures, he received this advice from a messenger of the gods:
"Work hard, raise your children well, provide for their future, and help your neighbors. Then you will fear death no more."
This issue of Foresight is dedicated to the memory of Charles S. Zern, who faced death without fear. He will be remembered and missed by all who were fortunate enough to know him.
FORESIGHT is a publication of De Maio & De Maio, Attorneys at Law. It is not intended as and does not constitute legal advice, nor does it create an attorney-client relationship. The information contained in this publication should not be acted upon without first obtaining the advice of a professional advisor.
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