As mentioned previously in this issue, decedents have a $5 million exemption from the federal estate tax for deaths in 2011 and 2012. Many states also impose tax on estates or estate beneficiaries. Depending on the state, people with a net worth of $1 million or more may leave their heirs with tax to pay. In addition, future legislation might reduce the federal estate tax exemption. As a result, you may want to take some actions by year-end 2011 that can reduce your heirs’ exposure to future estate tax.
Embracing the exclusion
Do you have more wealth than the amount you’re likely to need for yourself and perhaps for a surviving spouse? If that’s the case, use your annual gift tax exclusion for 2011 before year end. Once the calendar flips to January, you can use your gift tax exclusion for 2012, but you can’t go back and use any leftover exclusion from 2011. In 2011, the exclusion amount is $13,000 per recipient, and no limit exists on the number of recipients for which you can use the exclusion. Thus, married couples effectively have annual exclusions up to $26,000 per recipient to an unlimited number of recipients this year. Gifts in excess of $13,000 this year will be sheltered from gift tax by a $5 million lifetime gift tax exemption, per giver. Gifts in excess of the annual exclusion and the lifetime exemption are taxed at 35% in 2011 and 2012, the same rate that applies to estate assets over $5 million.
Great GRATs
Grantor retained annuity trusts (GRATs) may help reduce your taxable estate, if you anticipate having a large estate—and a potentially large estate tax obligation. If you act in 2011, you can take advantage of low interest rates, some relatively low asset values, and current tax law. The Obama administration has proposed tightening the rules on GRATs. Moreover, some Congressional leaders have expressed a desire to rein in the tax advantages of GRATs. You can take advantage of the current GRAT rules by creating a GRAT before any legislation takes effect. With a GRAT, you create a trust (so you’re the grantor) and contribute assets to it. You set the term of the trust and the annuity you’ll retain; that’s the payout you’ll receive during the life of the GRAT. After the trust term, the assets will pass to the trust beneficiaries you’ve named, perhaps your children.
Example 1: Sheila Simmons transfers stock worth $500,000 to a GRAT. She sets a trust term of four years and agrees to receive an annuity of $135,000 a year from the trust. Suppose that the current IRS interest rate table sets the present value of receiving $540,000 over the next four years at $500,000. If so, Sheila has not made a gift and owes no gift tax. This transaction gives Sheila a return on her money of around 3% a year.
In this example, Sheila transfers stock that has lost value in recent years. She thinks the shares will appreciate by more than 3% a year over the next four years. If that happens, assets will be left in the trust when the GRAT terminates. Sheila’s beneficiaries might receive shares worth $50,000, $100,000, or more when the trust terminates, free of any gift tax. If you create a GRAT, you’ll use the “Section 7520 interest rate” published monthly by the IRS, to put a value on the annuity you retain. The lower the interest rate, the greater the chance that the appreciation of the trust assets will result in a transfer of wealth to the trust beneficiaries with little or no gift tax.
Home runs
Qualified personal residence trusts (QPRTs) are similar to GRATs in some ways. You create a QPRT, transfer assets into it, set a trust term, and name trust beneficiaries who eventually will receive the assets from the trust. With a QPRT, however, the asset you transfer must be a house, and instead of receiving a flow of assets from the trust, as you do with a GRAT, you receive the right to use the house during the trust term. The house can be a principal residence or a vacation home. The transfer of the house to the QPRT is treated, for gift tax purposes, as a gift of the remainder interest in the house that the trust beneficiaries will receive at the end of the trust term. The value of the remainder interest is the value of the house at the time of transfer less the value of the right to use the house during the trust term. The value of the right to use the home is determined according to the length of the trust, the grantor’s life expectancy, and the Section 7520 interest rate as determined by the IRS for the month of the transfer. At the end of the trust term, you are allowed to live in or use the house if you wish. However, you must pay a fair market rent to the new owners—the QPRT beneficiaries. Such payments will move even more assets to your loved ones, free of gift tax.
Example 2: Phil Matthews, age 50, transfers a $1 million vacation home to a QPRT, setting the trust term at 25 years. Using interest rates in effect at that time, the value of Phil’s retained interest is about $700,000. Thus, Phil has made a gift of $300,000, which will be amply covered by his $5 million lifetime gift tax exemption. Phil can continue to use the vacation home for the next 25 years. Assuming appreciation of less than 3% a year, the home will be worth around $2 million when the QPRT expires. At that point, the $2 million home will pass to the trust beneficiaries with no gift or estate tax due. QPRTs might make sense now that real estate values are depressed, if you assume the property will gain value in the future. With a QPRT, you can enlarge the gift tax break by creating a trust with a long term. However, you must outlive the trust term to get the estate tax exemption. If you die during the QPRT term, the house will go back into your estate. Our office can illustrate how various QPRT terms will result in smaller or greater gift tax obligations.