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Dear Financial Advisors:
Here is a structure that can really benefit clients who want to transfer either
their personal residence, a second home, or both to their heirs without estate
or gift tax. Additionally, they can increase their estate through insurance or
financial investment without increasing their estate or gift tax liability. The
answer is that the real estate could be purchased by or placed into a Qualified
Personal Residence Trust (QPRT) with the beneficiary being an ILIT.
Why? I am glad you asked:
The QPRT is a trust that places the property in an irrevocable trust for the
benefit of the beneficiary (ILIT) but the owner retains a "retained interest"
i.e., the free use and enjoyment of the property for a period of time. At the
time the property is bought or transferred to the QPRT the value of the
property is a completed gift for gift tax purposes. However, the gift tax basis
is reduced by the retained interest. Depending on the length of the retained
interest, the owner can substantially, and I mean substantially, reduce the gift
tax that would be owed at the time of transfer. Why would anyone do this? I
am glad you asked that too: The property transfers to the ILIT without estate
tax, and the gift tax is substantially reduced.
Why an ILIT for a beneficiary? Good question, here is why:
First, if the owner dies during the term of the QPRT, then the property will be
included in the owner's estate, requiring an ILIT to be the back up. Secondly,
and most exciting, is that after the property is transferred to the ILIT, the owner
does not own it anymore, but can stay in the property if the owner pays
Why would anyone rent their own house? Another good question:
They must move the property outside of their estate, and retain no interests in
it for the avoidance of estate tax, but the cool thing is that the property is in
their own ILIT, with a third-party trustee (kids?), and their "rental payments"
would pay for their current premiums, or even better, the trustee of the ILIT could purchase more
insurance. What is more, the "rental payments" would not be gifts, requiring gift tax exclusion, but be
income. Since the ILIT will be a "grantor trust" for income tax purposes only, the trust will not have
to pay income taxes on the "rental payment" because the IRS sees it as a payment to yourself.
Huh? Let me give you an example:
In April of 2006, a 60 year old man buys a second home as his property sole and separate. He is
married but they agree to purchase the house as his separate property. The house is worth
$800,00.00. He transfers the house to a QPRT with a 7 year term. The value of the gift is
$488,792.00 (61.099% of the $800,000.00). The value of the retained interest in the house is
$242,128.00 (30.266% of the $800,000.00). Upon the end of the 7 year term, the QPRT transfers the
house to the beneficiary (an ILIT that was created at the beginning of this process.) The ILIT
currently holds a $500,000.00 life insurance policy and a year's worth of premium. The 60 year old
man then rents the house from the ILIT for fair market value. The ILIT then takes the rental income
to boost the insurance policy to $1,000,00.00. Upon the 60 year old man's death, after the 7 year term
of the QPRT, both the $1,000,000.00 policy and the second home go to the heirs.
Result: Client gets to have a second home, enjoy the second home, and pass it to his heirs estate tax
free. On an $800,000.00 house, appreciated to $1,125,680.00 over the term of the QPRT, assuming
he already has over a million dollars in estate tax exemption used in personal life insurance, the estate
tax would be $619,124.00. Instead, the Client gets to use the QPRT and his lifetime gift tax
exemption to transfer the property tax free. Additionally, the Client has grown his overall
distributable wealth to $1,000,00.00 of liquid insurance proceeds, and an additional $325,680.00 in
capital gains appreciation.
That totals a $1,325,680.00 benefit to the client.
To sum up, this program allows clients to purchase second homes in a buyer's market, protect them
from all creditors, but the mortgage company, transfer it gift and estate tax free, and increase their
distributable wealth to their heirs exponentially.