Estate Planning

Estate Planning Pitfall: Joint Assets

There's a common misconception that owning a home or another asset jointly with your spouse or child is an effective way to transfer the asset. It's true that, when people own property as joint tenants with rights of survivorship and one owner dies, the deceased owner's interest is automatically transferred to the survivor without going through probate. But joint ownership can have significant tax disadvantages.

Wasting An Exemption

For a married couple, it can waste one spouse's estate tax exemption. Suppose that you and your spouse jointly own a home. When you die, your interest automatically goes to your spouse tax-free under the marital deduction. Let's say that, when your spouse dies, the home is worth $10 million. Assuming a $5 million estate tax exemption and a 35% marginal rate, the home will generate $1.75 million in tax liability. You can avoid this tax by owning the home in equal shares as tenants-in-common and leaving your share to a credit shelter trust.

Adding your child's name to an asset's title as joint owner also can be a costly mistake. For one thing, it's considered an immediate, taxable gift of half of the property's value. What's more, joint ownership doesn't remove the home from your taxable estate (though an adjustment is made in computing the estate tax liability that offsets any prior gift tax reporting, so there's no double tax). Finally, it gives your child control over the property and exposes it to claims by the child's creditors.

Joint Home Ownership Problem

Income taxes can also be a concern, especially if a jointly owned home is your principal residence and you sell it, which would normally qualify for special tax treatment. If you own only 50% of the property, only that percentage is eligible (unless the joint tenant also resides in the home and meets the other requirements). Before adding a joint tenant to your property, consider alternative ways to hold the property and still accomplish your objectives.

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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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The Reason Married People Need A Will

Thursday, 09 July 2009 09:34

Many married people have never prepared a will, although they recognize that this is something that should be done. Perhaps the rather morbid title, “Last Will and Testament,” has caused them to delay taking action.

If you do not prepare a will, the state will draw one for you, and chances are very good that your survivors will not like the provisions. The legal term for dying without a will is “intestacy,” and the distribution of your property will be based on the intestacy laws of the state in which you reside at the time of death.

In the absence of a will, the Probate Court will appoint an administrator, such as a family member or local attorney. Then after a complicated procedure, all of your assets will be distributed according to the state’s formula.

Your estate consists of personal property (furniture, jewelry, clothes, automobiles), investments (cash, savings, securities), real estate, employee benefits (group insurance, retirement or profit sharing) and other items such as the proceeds of a lawsuit against someone who accidentally caused your death.

You cannot rely on joint property title as a substitute for a will because it does not solve problems arising with the second death. Some forms of joint title do not pass entirely to the surviving spouse.

Having a will drawn can prevent family disputes, and will give you the opportunity to be certain that your property will be distributed promptly to the parties designated as beneficiaries.

Your will should designate an Executor to carry out your bequests efficiently and promptly and with less expense than if there had been no will. See our posting on selecting an executor for your estate for more information. The will should also provide for flexibility in the administration of your estate. You may also wish to provide special bequests to non-profit organizations. Having a will prepared will also help establish a relationship with an attorney, which could be extremely valuable in the future. Naturally, a will should be periodically reviewed and updated to reflect changing personal circumstances and new tax laws.

Perhaps you’ll find it easier if, instead of thinking of Last Will and Testament, you think of fulfilling your wishes and controlling your own assets.

Brock and Associates, LLC is a financial planning firm specializing in asset protection and generational wealth preservation.

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