A QPRT Can Save Taxes

Planning for the disposition of your home can be a challenge. From a gift and estate tax perspective, the earlier you transfer an asset to your children or other beneficiaries, the lower the tax cost. But what if you want to continue living in your home indefinitely?

An effective solution to this dilemma is a qualified personal residence trust (QPRT). When you transfer your home to a QPRT, its value for gift tax purposes is heavily discounted and any future appreciation is removed from your taxable estate. Plus, you retain the right to stay in the home for many years.

Do you need a QPRT?

With gift and estate tax exemptions currently at record-high levels — $5 million for 2011 and 2012 — a QPRT may seem unnecessary. But even if your total estate is well within the exemption amount now, it's difficult to predict whether it will be within the exemption in, say, two years, let alone in 10 or 20 years.

Keep in mind that, unless the law is changed, the exemptions will drop to $1 million in 2013. In addition, as the economy rebounds and home and other asset values grow, there's an increasing chance that gift and estate taxes will become an issue for you down the road. And if your estate is already at or near the $5 million level, strategies like the QPRT will be valuable even if current exemption amounts are extended.

Regardless of your estate's size, there also are nontax reasons for using a QPRT. For example, it provides your home with some protection against creditors.

How does it work?

To take advantage of a QPRT, you transfer your home to an irrevocable trust, retaining the right to live there for a specified period. At the end of the trust term, the home goes to your children or other beneficiaries. But even after the term ends, you can arrange to continue living there in exchange for fair market rent.

QPRTs must meet several technical requirements. Most important, they're prohibited from holding assets other than a personal residence, insurance and enough cash to cover the trust's expenses. A QPRT is considered a "grantor trust," so you pay the mortgage, taxes and other expenses (and, if appropriate, deduct them on your income tax return).

What are the tax benefits?

Transferring your home to a QPRT is a taxable gift to your beneficiaries, but the value of the gift isn't the home's current market value. Rather, it's the present value of your beneficiaries' remainder interest in the home. That value is only a fraction of the home's current value, and at the end of the term your beneficiaries receive the home tax-free, regardless of how much it has appreciated.

To determine the remainder value, you take the home's current fair market value and subtract the present value of your right to live in the home during the trust term. The value depends on several factors, including the current market value of the home, your age, the length of the term and the IRS-published "discount rate" in effect when the QPRT is established.

Generally, the lower the home's current value, the older you are, the longer the trust term and the higher the discount rate, the lower the value of the remainder interest. Real estate values are generally depressed now, so it may be a good time for a QPRT — even though discount rates are also low.

What are the pitfalls?

QPRTs require careful planning to preserve their tax advantages. One critical consideration is mortality risk. For a QPRT to work, you must outlive the trust term; otherwise the home's full value will be included in your estate. So selecting the right trust term is a delicate balancing act. A longer term reduces the size of your gift but a shorter term minimizes mortality risk.

Another pitfall involves what happens when the trust term ends. If you continue to live in the home but don't pay fair market rent, the IRS may treat the transaction as a transfer with a retained life estate and include the home in your estate. The best way to avoid this result is to sign a written lease and follow its terms.

A safe bet?

If you plan to stay in your home indefinitely, a QPRT is worth a look. It has the potential to produce significant tax savings and, with careful planning, has little downside. Before you take action, discuss with your estate planning advisor whether a QPRT is right for your family's situation.

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Major Economic Dominos Falling: Prime Defaults

Written by Hank Brock, President & CEO

I have been a keynote speaker at a number of conferences in the last year such as The MoneyShow, FreedomFest, Live and Invest Overseas, TTP and several offshore venues. The topics have all centered around a number of documented dominos in the inevitable worldwide economic collapse and why the wealthy will be impacted most.

Though the general public is slowly getting more familiar with the dominos/terms such as derivatives, falling dollar, U.S. debt and world reserve currency, no one is connecting the dominos the way we do. My new book Dominos of Destruction chronicles 14 of some two dozen economic dominos that have or will yet fall. Admittedly, it's a bit scary, but staying aware of world economic conditions is a powerful way to remain prepared.

Domino #4: Prime Borrowers Default

For example Domino #4 Prime Borrowers defaulting is wobbling as we write this issue of the newsletter.

Mortgage defaults are a typical outcome of recession. The rising unemployment and flat-to-declining property values eat away at homeowners' ability and desire to continue making those monthly payments. In previous recessions, however, the defaults have been focused on prime borrowers. This is because subprime borrowers weren't able to buy homes before 1999; there was no such thing as subprime mortgage borrowers, and so they didn't default.

Massive Prime Defaults

In this current cycle, we are just beginning to see massive prime borrower defaults. Prime borrowers have been hanging on, despite job loss, by burning through their savings. They are liquidating their own assets just to maintain that credit rating. Unfortunately, this is not a long-term solution. The rising and/or the persistent unemployment trend has dragged on for months and shows no signs of appreciably changing for the better. In no uncertain terms, continuing unemployment will cause a wave of prime borrower mortgage defaults.

Default Trend Started in 2009, continues

In September of 2009, The Wall Street Journal reported that this trend had already begun. Prime borrower delinquencies had already shown a marked increase. This news was followed by a December, 2009 report from regulators. The Office of the Comptroller of the Currency and the Office of Thrift Supervision indicated that 60-day past-due prime mortgages had doubled in the third quarter of 2009. Also in that quarter, one of out every six FHA-backed loans was at least one payment past due. Further, the economists behind the S&P/Case-Shiller Home Price Index and Credit Suisse Loan Performance report suggest the foreclosure crisis continuing well into 2014 or 2015. (see chart)

According to Greg Fielding, a contributing writer to The New York Times and real estate expert, "Because mortgage interest rates are low, ‘resets' are less of a problem right now. Today, ‘recasts' are the real threat. A recast refers to the changing of payment options for Option-Arm loans. Many borrowers bought the biggest home they could "afford", using minimum payments to qualify. When the minimum payment option disappears, their monthly expense will "recast" to a substantially-higher amount, regardless of what interest rates do.

Strategic Defaults

During the last 12 months a new kind of Prime Borrower default/foreclosure has emerged: The strategic default. This is a highly qualified borrower that is so far underwater with his mortgage that he views it taking 5-10 years before his house will be valued at the loan amount once again. They CAN pay, but choose not to. The cash they save continuing to live in their house while the lender figures how and when to boot them out. Plus, making a lower rent payment less than their mortgage means they can potentially have a pile of cash to buy back into the housing market 1-5 years downstream. Shocking? Wait, there's more. There is an entire new industry emerging helping homeowners facilitate strategy defaults. Companies like www.youwalkaway.com and www.strategicdefault.com are helping people navigate the process. There are even major movies built around the theme i.e. Tom Hanks and Julia Roberts in Larry Crowne-a movie about a home center executive who loses his job and home, then discovers a new life and love after strategic default. My guess, you've not seen anything yet.

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Downgrade to Disaster

Think the US bond downgrade is no big deal. Think again.

For years, all of Hank's public presentations have included a slide that read "...Bottom-line: U.S. to be downgraded." On August 5, 2011, Standard and Poor's finally downgraded the United States credit rating from AAA to AA+, for the first time in history putting the financial strength of America below that of even some companies. This was S&Ps response to Congress "cutting $2.1B from the deficit over 10 years" which is farcical reporting by the press in collusion with Washington. That report was like a pouting child saying "Mom, let me put $600 more on the credit card at the mall this afternoon!" and mom putting her foot down and saying, "No! no! no! I'll only let you put $550 more on the credit card!!!" It was merely a reduction in the amount of debt increase. Any parent knows that with that kind of negotiations, all the child has to do is ask for $50 more than he wanted in the first place.)

Indeed, a recent report showed Apple Computer with more cash on hand than the U.S. Treasury ($76B to $74B, and of course some companies have much more). This is no indicator that future federal deficit spending will be reduced, as politicians and the liberal press are retorting to "See? Nothing happened!" reporting, and keeps the public rhetoric low for an election year and diffuses public pressure for any real spending controls Washington does not want. But make no mistake: it raises borrowing costs for the U.S., is a major blow to national sovereignty (how can we be sovereign when in debt to foreigners? And foreigners can dictate what they will and won't finance? A war? A spending program?), gives impetus to world-wide voices to scrap the Dollar as the world's reserve currency, and the implications go on-and-on. Greenspan's retort was, "we can always print more," which is simply signaling bankruptcy (printing/inflation/paying off debts at pennies-on-the-dollar, which is bankruptcy, and smart foreigners understand this).

Fortunately, China is forced to buy the very bonds it despises to forestall wrecking its own economy, but even China has dropped its financing of U.S. Treasury notes from over 20% of our deficit in 2008 to about 5%. Quantitative Easing 3 (QE3, more printing) is on its way, as the Fed prints money from thin air to buy the bonds no-one else will at today's artificially low interest rates, hoping to keep our economy from wrecking during an election year, which the Fed has committed to do until 2013. All this serves to devalue the dollar, inflation, and more pent-up problems behind the dam ready to burst.

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Bond Credit Ratings 101

Credit rating agencies have been criticized for not providing adequate warning about risky securities. Despite their recent high-profile failings, credit ratings remain a useful tool for bond investors, as long as their limitations are understood.

Three credit rating agencies

Three major credit rating agencies - Moody's, Standard & Poor's and Fitch - issue ratings on the credit worthiness of companies and public entities that issue debt, as well as ratings on the debt itself. Ratings represent an agency's opinion of a bond issuer's ability to make scheduled interest payments and to repay principal at maturity. However, a high rating is only a guide - not a guarantee of creditworthiness.

The agencies issue ratings in a letter format. For example, the ratings from Standard & Poor's and Fitch range from AAA for the highest-quality bonds to D for bonds in default, meaning the issuer has stopped making interest payments.

The agencies also use plus and minus signs to indicate stronger or weaker ratings within certain groups. Moody's uses a different but similar scale, with Aaa as the highest rating.

Ratings, yields and risk

There typically is an inverse relationship between a bond's credit rating and its yield. Riskier, lower-rated bonds tend to offer higher yields than comparable higher-rated bonds. The higher yield compensates investors for the added risk they take in buying a lower-rated bond. Bonds in any of the four highest-rated groups (AAA, AA, A and BBB) are considered investment grade. All bonds below investment grade are classified as high yield, speculative or "junk" bonds - all terms with roughly the same meaning.

Because many institutions can't own bonds below investment grade, the investment-grade bond market is more liquid than the high-yield market. This leaves more opportunity to find bargains in the high-yield market. And when a bond is upgraded from high-yield to investment-grade status, it typically means a significant boost in price.

Lower-rated bonds may offer better return potential, but their risks are real. When an issuer defaults on a bond, not only does it stop paying interest, but it also may not be able to pay back your principal.

In an analysis by Standard & Poor's covering the 15 years from 1995 through 2009, the average default rate of U.S. corporate bonds in all investment-grade categories was only 4.62%. Compare that to the 32.41% average default rate for high-yield corporate bonds. In the lowest-rated high-yield groups, including CCC, CC and C, the average default rate was a whopping 62.30%.

Delayed downgrades

In an ideal world, credit ratings would change along with an issuer's financial condition. In the real world, though, rating agencies don't always respond promptly, especially when it comes to downgrading or lowering a company's credit rating.

When a company's credit rating is downgraded, it might be forced to pay higher interest rates on its bank loans or even repay the loans on an accelerated schedule. So rating agencies often drag their feet about issuing downgrades.

To cite one infamous example, defunct energy trader Enron carried an investment-grade rating until just four days before the company filed for bankruptcy in December 2001. More recently, the rating agencies were slow to recognize the risk in derivative securities held by Bear Stearns and Lehman Brothers - both of which collapsed in the 2008 financial crisis.

That's why, if you're buying an individual bond, it's important to research an issuer as carefully as you would if you were buying a stock. Additionally, even in a portfolio of highly rated bonds, diversifying across multiple issuers - some advisors say a minimum of 10 - as well as a variety of market sectors is likely a good idea.

Using bond credit ratings successfully

Bond ratings can be useful in your investment research, as long as you use them as one analytical tool among many. The key is keeping their limitations in perspective and incorporating the same principles of sound investing that you would apply to stocks - such as diversification - to dampen risk.

The Worker, Homeownership and Business Assistance Act of 2009 (WHBAA)

The Worker, Homeownership and Business Assistance Act of 2009 (WHBAA) was signed into law Nov. 6. Not only does the act extend unemployment benefits for millions of Americans, but it also extends and enhances the homebuyers credit and the five-year net operating loss (NOL) carryback election for businesses.

The Homebuyers Credit

Last year, a refundable tax credit equal to 10% of the purchase price of a principal residence was made available to qualified first-time homebuyers. This credit was set to expire July 1, 2009, and generally required repayment. But in February the American Recovery and Reinvestment Act of 2009 (ARRA) extended its availability to purchases made before Dec. 1, 2009, and generally removed the repayment obligation for qualifying purchases after Dec. 31, 2008.

WHBAA has now extended the credit to purchases made before May 1, 2010 — or July 1 if a binding contract is in place before May 1 to close on the purchase before July 1.

The maximum credit remains at $8,000 ($4,000 for married filing separately) for first-time homebuyers. For purposes of the credit, a first-time homebuyer is someone who has had no ownership interest in a principal residence in the United States during the prior three-year period.

In addition, WHBAA expands the credit to many "long-time" homeowners purchasing a subsequent home. The maximum credit for these taxpayers is $6,500 ($3,250 for married filing separately). To qualify, the homeowner must have maintained the same principal residence for any five-consecutive-year period during the eight-year period ending on the purchase date of a subsequent principal residence.

WHBAA also significantly increases the modified adjusted gross income (MAGI) phaseout ranges for the credit. For qualifying purchases made after Nov. 6, 2009, the phaseout range is $225,000-$245,000 for joint filers, $125,000-$145,000 for single filers.
WHBAA does add a few new limits. Effective for purchases made after Nov. 6, 2009, no credit is allowed if:

• The home's purchase price exceeds $800,000 (regardless of regional market factors),
• The homebuyer (or his or her spouse) is related to the seller,
• The homebuyer is under age 18 on the date of purchase (unless his or her spouse meets the age requirement), or
• The homebuyer is the dependent of another taxpayer.

There are other expansions, enhancements and limitations as well, so it's important to consult your tax advisor to determine whether you're eligible for the credit.

The NOL Carryback

Generally, when business deductions exceed gross income, the difference is an NOL for tax purposes and may be carried back two years to offset income. This generates a tax refund, providing a cash infusion in times of loss. Any loss that's not absorbed is carried forward up to 20 years.

ARRA allowed taxpayers to elect to carry back 2008 NOLs from qualifying small businesses (businesses with average gross receipts of $15 million or less for the three years ending with the loss year) for three, four or five years instead of two. WHBAA expands the longer carryback option to businesses that don't qualify as "small" and extends it to 2009 NOLs.

Under WHBAA, generally taxpayers can apply the longer carryback to only one tax year's NOL and to offset only 50% of income in the fifth year back, 100% in the other four. For qualifying small businesses, taxpayers can apply the longer carryback to both 2008 and 2009 NOLs, and the 50% limit applies only to 2009 NOLs. Taxpayers also have the option to use the normal two-year carryback or to waive the carryback period entirely and carry the loss forward.

Are you eligible?

The extension and expansion of the homebuyers credit and the five-year NOL carryback option could provide you or your business with a valuable tax-saving opportunity. But the rules surrounding these breaks are complex. We'd be glad to help you determine whether you're eligible and, if so, how you can make the most of these breaks.

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