Foresight -- Devoted to Estate and Tax Planning
3rd Quarter, 1997 -- Vol. 3, No. 3
© 1997 De Maio & De Maio

IN THIS ISSUE:

Feature Article:

Recent Developments:

The Lighter Side:


Feature Article

The Personal Residence Life Estate Trust:
A New Planning Tool

By Andrew J. De Maio, Esq.

Author's Note: This article contains hypertext links to Technical Notes that include citations to legal sources and a discussion of technical issues in greater detail. They are intended primarily for the legal and tax professionals who read Foresight.

The qualified personal residence trust (QPRT), discussed in the 3rd Quarter1996 issue of Foresight, has become an increasingly popular, tax-smart way to transfer the family home to children or other family members. But it suffers some disadvantages. The trust must last for a pre-set term, such as five years. At the end of the trust term, the creator of the trust (the grantor) must either vacate the home or pay rent to the trust's ultimate beneficiaries. If the grantor does not outlive the trust, the tax benefits are lost.

Two recent federal court decisions /1/ suggest the availability of a new variation on the QPRT: a personal residence trust that lasts for the lifetime of the grantor, rather than for a fixed term. Because the trust lasts for life, the grantor does not have to worry about being put out of his or her home, or paying rent. Unlike the QPRT, however, the beneficiaries must purchase their interest in a life estate trust, rather than receiving it as a gift.


How it works

A life estate is the right to use something during your lifetime. If you own a life estate in a home, you have the right to live there rent-free. But you cannot leave the home to someone in your will, because your interest ends at your death. A remainder interest, on the other hand, is the right to future ownership of property, after someone's life estate ends.

The personal residence life estate trust is a means of selling to your children or other heirs the remainder interest in your home. As beneficiary of the trust, you retain the life estate: the right to continued use of the residence. The tax regulations contain actuarial tables that determine the respective values of the life estate and the remainder. /2/


An example

Jack's home is worth $300,000. Over the years, it has appreciated in value, and he is convinced that the growth will continue. He decides to transfer the home to his three children using a personal residence life estate trust.

According to IRS actuarial tables, the value of the right to use the home for Jack's lifetime (he just turned 50) is 82.3% of the home's value, or about $247,000. The remainder is worth about $53,000. Jack's children agree to purchase from him the remainder interest for $53,000. /3/ In return for this payment, Jack creates the trust and deeds the home to it. As beneficiary of the trust, Jack has free use of the home for as long as he lives. Upon his death, the trust ends and the home passes to the children.


Estate tax aspects

Normally, when you transfer an asset and retain life rights, the asset remains subject to estate tax under section 2036 of the tax code. But section 2036 contains an exception: it does not apply to a sale for "adequate and full consideration." The U.S. Courts of Appeal for the Third Circuit (in which New Jersey is located) and the Fifth Circuit have recently held that in the case of a remainder interest, adequate and full consideration means the value of the remainder as calculated under the IRS actuarial tables. That means that as long as Jack's children pay him the $53,000 purchase price, the home will not be subject to estate tax at the time of Jack's death. /4/ Just as important, if the home grows in value, any future appreciation completely escapes estate and gift tax.

This analysis is the subject of some debate among courts. The recent favorable Third Circuit and Fifth Circuit decisions conflict with the view taken by other courts in a number of other cases. /5/ In those cases, the courts held that "adequate and full consideration" means the full value of the home, not just the value of the remainder interest. /6/ In our example, that would mean Jack's children would have to pay him $300,000 now for the right to own the home many years in the future. Obviously, this makes little sense from either an economic or a tax perspective. /7/ Until the law is further clarified, any planning involving sales of remainder interests involves some risk. /8/


Valuation is critical

To come within the "adequate and full consideration" exception, the price paid by Jack's children must be no less than the value of the remainder interest. If the amount paid by the children is too low (by even one dollar), the entire value of the home will be included in Jack's estate at the time of his death. This means that it is critically important to obtain a reliable real estate appraisal that errs, if at all, on the high side. For an additional margin of safety, a "cushion" may be added to the appraised value when calculating the price to be paid for the remainder interest. After the sale, Jack must be careful not to make any improvements to the home without receiving adequate consideration from the children.


Getting paid

In our example, Jack received payment from his children in cash at the time of the creation of the trust. That is the simplest and safest way to structure the sale. However, other options are available. The kids may sign and deliver a promissory note, agreeing to pay the price over time with interest. /9/ Or they may agree to pay Jack a "private annuity": a fixed dollar amount each year for the remainder of his lifetime. /10/ Here again, the amount that the children pay is based on actuarial tables. A benefit of the private annuity is that the payments end at Jack's death, leaving nothing to be taxed as part of his estate. There is a corresponding disadvantage: if Jack lives to age 100, the purchase will be a very expensive one for the children.

A strategy that combines some features of an installment sale and a private annuity is a self-canceling installment note (SCIN). A SCIN is for a fixed amount, but the obligation to pay terminates on Jack's death. It must be carefully structured to comply with the applicable tax rules.


Income tax aspects

Jack may be required to pay some income tax when the trust is created. His sale of the remainder interest may produce a taxable capital gain. /11/ Under the newly enacted Taxpayer Relief Act of 1997, the sale is not eligible for the $250,000 exclusion that normally applies to the sale of a principal residence. /12/

During Jack's lifetime, he is treated as the owner of the home for income tax purposes. /13/ Thus, he can deduct the real property taxes he pays.

When the children receive the house at Jack's death, their income tax basis is the amount they paid for their interest: $53,000 in our example. If the house is worth $400,000 at Jack's death and the kids sell it right away, they will pay income tax on $347,000 of capital gain. Nevertheless, at capital gains rates, this income tax cost may be a small one compared to the estate tax savings from the arrangement.

In the past, this capital gain problem could be avoided by Jack buying back the residence from the trust during his lifetime. Regulations proposed by the IRS last year require that the trust prohibit such a sale. /14/ Those regulations have not yet been finalized, and their validity and effectiveness remains the subject of debate.


Getting out

What if Jack wants to sell the home during his lifetime, or becomes disabled and can no longer live there? The trust can sell the residence and reinvest the proceeds in another home for Jack. If a substitute residence is not purchased, the trust must pay Jack annuity payments for the rest of his lifetime, calculated under a formula in the tax regulations. /15/ These rules are similar to those governing traditional QPRTs. And like a traditional QPRT, the capital gain from the sale is taxable to Jack. /16/ If the home is his primary residence, he should qualify for the newly enacted rule excluding $250,000 of capital gain on the sale of a principal residence./17/


Final thoughts

Until the law is further developed, the tax treatment of the personal residence life estate trust and other remainder interest sales remains somewhat clouded with uncertainty. Nevertheless, this type of trust planning is worth considering for those who want to save estate taxes, but are unwilling to give up control of their home. The personal residence life estate trust permits the ultimate beneficiaries to purchase the home for a small percentage of its current worth. It completely eliminates estate tax on growth in the home's value after the transfer. Unlike the QPRT, it does not require that the grantor survive for a fixed term in order to achieve tax benefits. And it allows the homeowner to convert an illiquid asset (a home) into cash or other consideration that can be used to make further gifts.

 


RECENT DEVELOPMENTS

Tax Bill Offers Estate, Gift Tax Relief
H.R. 2014

The Taxpayer Relief Act of 1997, passed by both houses of Congress on July 31 and signed by the President on August 5, includes significant estate and gift tax relief. A few of the major changes are summarized here.

Increase in Unified Credit. The Bill gradually increases the amount that is exempt from estate tax from the current $600,000 to $1 million, between 1998 and 2006. After 2006, the exempt amount will remain at $1 million, and will not be indexed for inflation.

Exclusion for Family Businesses. The new law allows an executor to elect special estate tax treatment for qualified "family-owned business interests" if such interests comprise more than 50 percent of the estate. In general, this provision excludes the first $1 million of value in qualified family-owned business interests from a decedent's taxable estate. But there are lots of details and limitations.

Many of the tax-saving provisions in the new law will be phased in over time. The family business exclusion, however, actually becomes less valuable as time goes on. That's because the Bill limits to $1.3 million the combined exemption resulting from the unified credit and the family business exclusion . For example, in 1998, when the unified credit exempts $625,000, the family business exclusion can exclude an additional $675,000. ($625,000 + $675,000 = $1.3 million.) However, in 2006, when the amount exempt under the unified credit is $1 million, the family business exclusion will shelter only $300,000 of business assets.

Indexing for Inflation. The $10,000 annual exclusion for gifts, the $750,000 ceiling on special use valuation of farm and business assets, the $1,000,000 generation-skipping transfer tax exemption, and the $1,000,000 ceiling on the value of a closely-held business eligible for the special low interest rate (discussed below), will be indexed annually for inflation, beginning in 1999.

Installment payment of estate tax on business assets. Under current law, the estate tax on closely held business interests may be paid over a 14-year period, with interest. A special interest rate of 4 percent applies to the estate tax attributable to the first $1 million in value of the business interests. The new law lowers the special interest rate from 4 percent to 2 percent. For business interests larger than $1 million, interest on the excess is calculated at 45% of the rate normally applicable to underpayments of tax. However, the new law provides that the interest paid is not deductible against either estate or income taxes. A proposal that would have extended the time period from 14 years to 24 years was not included in the final legislation.

Repeal of Excess Accumulation and Distribution Taxes. The 15% excise tax on excess accumulations in and excess distributions from IRAs and retirement plans is repealed, effective December 31, 1996. This tax has been widely criticized as a disincentive to retirement savings. See, for example, Jeffrey Birnbaum's article entitled A Timely Death For a Dumb Tax in the July 21, 1997 issue of Fortune. Interestingly, the section of the Bill repealing the tax is included in Title X, entitled "Revenue-Increase Provisions."

Children Must Pay Tax on QTIP Trust
In re Marital Deduction Trust under the Will of Herbert J. Adair, N.J. Supreme Court (June 27,1997)

When he died in 1985, Herbert J. Adair left $6 million to a QTIP (qualified terminable interest property) trust for the benefit of his wife Delia. All of the income from the trust was payable to Delia during her lifetime. Upon her death, the trust directed that the assets be paid to Herbert's three children from a prior marriage. Use of the QTIP trust permitted Herbert to defer estate tax on the trust assets until Delia's death. A QTIP trust is eligible for the estate tax marital deduction, but is subject to tax in the surviving spouse's estate.

Delia died in 1993, a resident of Florida. "Who pays the tax?" was the issue before the New Jersey Supreme Court in this case. The federal estate tax was paid from the trust, according to directions in Herbert's will. But there was no mention in the will of Florida estate tax, which amounted to over $1 million. The trustee of the trust refused to pay the tax, and contended that it should be paid by Delia's estate.

After Herbert's death, Delia's relationship with Herbert's children had become "strained and increasingly hostile." She left her estate to three of her relatives, not to the children. The personal representative of her estate argued that the estate should not have to pay tax on assets that passed to the children, outside of the estate.

Under Florida law, death taxes in this situation are to be apportioned to those who receive the property that generates the tax (the children in this case), unless the surviving spouse otherwise directs by will or other instrument. Delia's will and standby trust did not specifically mention the QTIP trust. They contained what the court described as "generic, boilerplate provisions" dealing with tax apportionment. On the other hand, it was clear from the documents and the surrounding circumstances that Delia intended to disinherit her step-children, not to benefit them.

The trust should be required to pay the tax, ruled the court. Nothing in Delia's will or trust negated the otherwise-applicable legal rules. This placed the ultimate burden of the tax on the children, who received the trust assets.


Child Support Obligation Continues after Death
Kiken v. Kiken, New Jersey Supreme Court (June 12, 1997)

Donald and Ellen Kiken were divorced in 1982. The divorce decree required Donald to pay alimony to Ellen and child support to their son David, who was then five years old. The divorce decree also provided that Donald and Ellen would "pay for college for the infant child commensurate at the time with their income and assets."

Donald died in 1986 at the age of 44. Eight years later, David was admitted to the University of Pennsylvania. Ellen applied to the court for an order requiring Donald's estate to pay for David's college education. She argued that the part of the divorce judgment providing for college expenses was binding on Donald's estate, which was still being administered. The estate, opposing Ellen's application, contended that the obligation to contribute to college costs was effective only during Donald's lifetime.

The court ruled in Ellen's favor. Although the part of the divorce decree dealing with educational expenses did not contemplate the early death of either party, the obligation was enforceable against the estate.

Comment: Donald was a real estate developer. The administration of his estate was a lengthy process, and the estate remained open, apparently because it contained illiquid real estate interests. However, because child support provisions may include contingent obligations extending well into the future, the Court's ruling potentially applies even after an estate has been closed and distributed.


Written Directive Controls Disposition of Remains
Bruning v. Eckman Funeral Home, 300 N.J. Super. 424, (App. Div. May 7, 1997)

John Peter Bruning and Ruth Bruning were married in 1939. Years later they separated, but never legally divorced. For at least six years before his death in 1986, John lived with another woman, Denise Helstowski. In February 1993, John purchased a mausoleum and expressed his wish to be interred there when he died. He signed a written directive stating: "...my final burial will be with my beloved Denise Helstowski at Rolling Hills Gardens of Marlboro."

After John's death, Helstowski made funeral arrangements in accordance with the directive. Ruth objected and claimed the right to control the disposition of the remains. The applicable statute, N.J.S.A. 8A:5-18, gives the surviving spouse the right to make funeral and burial arrangements, unless"other directions" have been given by the decedent or by a court.

Ruth argued that the instructions left by John were ineffective because they were not contained in a valid will. The court disagreed, and held that the formality of a will is not required. The directions may be contained in a written document other than a will, or may even be given orally. The court has the power to override the instructions if there is a valid reason to do so. But the decedent's directions are "entitled to respectful consideration and are allowed great weight," according to the court. The case was remanded for further findings by the trial court as to John's intentions.

 


THE LIGHTER SIDE:

Watching the Door

A noted criminal lawyer was making the closing argument for his client accused of murder, although the body of the victim had never been found. The lawyer dramatically turned to the courtroom's clock and, pointing to it announced, "Ladies and gentlemen of the jury, I have some astounding news. I have found the supposed victim of this murderto be alive! In just ten seconds, she will walk through the door of this courtroom." A heavy silence suddenly fell over the courtroom as everyone waited for the dramatic entry, but nothing happened.

The smirking lawyer continued, "The mere fact that you were watching the door, expecting the victim to walk into this courtroom is clear proof that you have far more than a reasonable doubt as to whether a murder was committed." Tickled with the impact of his cleverness, the cocky lawyer confidently sat down to await acquittal.

The jury was instructed, filed out, and returned within ten minutes with a guilty verdict.

When the judge brought the proceedings to an end, the dismayed lawyer chased after the jury foreman: "Guilty? How could you convict? You were all watching the door!"

"Well," the foreman explained, "most of us were watching the door, but one of us was watching the defendant, and he wasn't watching the door."

-- Courtesy of Frederick C. Fray (fcf@webspan.net)



FORESIGHT is a publication of De Maio & De Maio, Attorneys atLaw. It is not intended as and does not constitute legal advice,nor does it create an attorney-client relationship. Theinformation contained in this publication should not be actedupon without first obtaining the advice of a professionaladvisor.

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