Tax Strategies for Transferring Family Homes

Tax Strategies for Transferring Family Homes

Outright Gifting of Property Interests

From the donor's perspective, the simplest alternative for transferring a family home to children and grandchildren is to make outright gifts of real property interests. In this Analysis, Nancy G. Henderson discusses gifting with the annual exclusion, issues with gift tax, a relevant perspective of tenancy-in-common agreements, and continued use of the property. She writes:

     (1)  Outright Gifting with the Annual Exclusion. With the possible exceptions of certain vacation timeshares and campground memberships, it is unlikely that there are many family properties that could be entirely transferred to children in a single round of gifts using the gift tax annual exclusion. However, gifts of fractional interests in real property are, in most cases, gifts of present interests in property that qualify for the gift tax annual exclusion. Further, such fractional interest transfers should be discounted for gift tax valuation purposes by some reasonable factor that takes into account the lack of marketability and lack of control inherent to co-ownership of real property as tenants-in-common.

     The annual exclusion is indexed for the effects of inflation, presently allowing a donor to give up to $13,000 in cash or property to any individual donee during any calendar year free of gift tax. The annual exclusion can be effectively doubled if the donor's spouse participates in the gifting program, either because the donor's spouse is a co-owner of the property or because the donor's spouse agrees to gift splitting. It is therefore possible to make incremental annual gifts of interests in a family home to children, grandchildren or others which, over time, can result in the complete transfer of the property without gift tax.

     There are many disadvantages to this strategy, however. First, annual gifting of interests in real property generally requires a reappraisal of the property before each round of gifts to maximize the benefits of the exclusion without exceeding it. Such appraisals can be expensive, particularly if they involve the determination of the appropriate fractional interest discount, which typically must be done by a business interest appraiser or an expert in the valuation of Tenancy in Common interests. Another disadvantage of gifting direct real property interests in small annual increments is that, over time, title to the property can become complicated, and it may be difficult after several years of fractional interest transfers to calculate the interests acquired by each donee as compared to the donor's remaining interest in the property.

(footnotes omitted)

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Transferring Family Homes: Family Limited Partnerships, LLCs, and Trusts

An alternative to gifting direct interests in a family home to children or other family members is to transfer the property to a family limited partnership (FLP) or a limited liability company (LLC) and to make gifts of interests in the partnership or LLC to children or other family members. In this Analysis, Nancy G. Henderson discusses the transference of family homes via FLPs, LLCs, and trusts. She writes:

Family Limited Partnerships and LLCs.

     There are numerous potential benefits of transferring family homes into a FLP or LLC. First, because title to the property will be held at the entity level, transfers of interests in the partnership or LLC will not negatively impact upon the chain of title to the property. Correspondingly, because no partner or member will have a direct interest in the property, the property will be protected from liens arising from the debts and liabilities of the various partners or members. Further, the partnership agreement or operating agreement ("entity agreement") can be drafted to address a variety of challenges of co-ownership, such as the use of the property by the partners and the members, the management of the property, and the sharing of the expenses related to ownership of the property. Further, if a partner or member fails to contribute his or her agreed share of the expenses of owning and maintaining the property, the penalties imposed will be easier to implement. Specifically, upon the failure of a partner or member to make a required contribution, the entity agreement can dilute such partner's or member's interest in the partnership or LLC in a manner that is essentially self-executing. The entity agreement can also address the transferability of interests in the partnership or LLC to third parties, it can provide for rights of first refusal and other methods to restrict the transfer of entity interests to non-family members, and it can provide a means for the resolution of disputes between partners or members.

     A question that arises when using FLPs and "FLLC"s in the context of estate planning for family homes is whether discounts for lack of control and lack of marketability will apply for purposes of determining the gift or estate tax value of interests in such an entity. Generally, a limited partnership or LLC can be formed under state law to accomplish any business or investment purpose not otherwise prohibited from operating in that form. Even though real property held by a limited partnership or LLC may be made available for the personal use of its partners or members, such property also has significant investment value. The Tax Court has consistently held that, so long as a partnership or limited liability company is validly formed under state law, and if there is no reason to believe that a hypothetical willing buyer would disregard the partnership, then the partnership form should be respected for gift and estate tax valuation purposes. Therefore, an entity should possess a valid business or investment purpose even if the principal asset of that entity is a family home or other family property.

(footnotes omitted)

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Tax Planning Strategies for Transferring Family Homes: Dynasty Trusts

If a property owner intends for property to remain in trust for the use and enjoyment not only of the owner's children, but for future generations of descendants, a "dynasty trust" can be an excellent vehicle to accomplish this objective. Careful consideration must be made as to the effect of the generation-skipping transfer tax upon the donor, the trust, and the trust beneficiaries. In this Analysis, Nancy G. Henderson discusses the general gifting of property interests in trust, family home transfers and dynasty trusts. She writes:

     An alternative to gifting direct interests in a family home to children, the donor could establish a Trust for the benefit of children or other family members and make gifts of interests in the property to such a trust during life and/or at death. In many cases, it is the intent of the donor that the property will remain in trust for the use and enjoyment not only of the donor's children, but for future generations of the donor's descendants. A trust of this nature, sometimes referred to as a "dynasty trust", can be an excellent vehicle to accomplish this objective so long as careful consideration is provided to the effect of the generation-skipping transfer tax upon the donor, the trust and the trust beneficiaries. A significant assumption for purposes of this article is that there are federal estate and generation-skipping transfer (GST) taxes.

General Gifting of Property Interests in Trust

     While there are many issues to consider in drafting a trust as an alternative to making outright gifts of fractional real property interests or creating a family partnership or LLC, certain issues bear particular mention in the context of family homes. First, the trust agreement should establish the rules for the use of the property by the trust beneficiaries, as well as a plan for the succession to a beneficiary's interest in the trust upon the beneficiary's death. In this respect, a significant benefit of holding a family home in a trust is, so long as no beneficiary possesses the right to withdraw the trust property (or other similar powers that constitute a general power of appointment), and so long as the trust instrument includes a spendthrift clause prohibiting the transfer of a beneficiary's interest in the trust or its property, the trust property should be protected from the claims of the beneficiary's creditors. Further, the terms of the trust could insure that, for as long as the trust is permitted to continue under applicable state law, the trust property will remain in the family.

     . . . .

Dynasty Trusts

     When transferring a family home to a trust, unless the donor's GST tax exemption is applied to the transfer, or the transfer qualifies for the GST tax annual exclusion, the GST tax will be imposed upon the initial transfer if that transfer is a "direct skip." The transfer of a residence to a trust will be a "direct skip" only if the trust is a "skip-person" for GST tax purposes. A trust that will hold a residence for the collective benefit of the donor's children and grandchildren will not be a "skip-person" and, therefore, the GST tax will not be imposed upon the initial transfer of the residence to the trust. On the other hand, unless the donor's GST tax exemption is applied to each transfer that is made to the trust (or a late allocation of the exemption is properly made), and unless the portion of the donor's GST exemption so applied is sufficient to render the "inclusion ratio" of the trust zero (0) for GST tax purposes, a GST tax will be imposed upon each distribution from the trust to a "skip-person" (a "taxable distribution"). Further, a GST tax will be imposed upon the entire trust upon the first date that the only remaining beneficiaries of the trust are skip-persons (a "taxable termination"). In either case, the amount of the GST tax imposed will depend upon the inclusion ratio of the trust. If the trust has an inclusion ratio one (1), meaning no portion of the donor's GST tax exemption was applied to the trust, then the GST tax will be imposed at the maximum estate tax rate, which, applying 2009 tax rates, is 45%. If, however, the inclusion ratio of the trust is, for example, .4, meaning the donor's GST tax exemption was only sufficient to exempt 60% of the value of the trust from the imposition of GST tax (a "mixed inclusion ratio), the GST tax will be imposed at 40% of the highest marginal estate tax rate, which, applying 2009 tax rates, would be 18% (40% of 45%).

(footnotes omitted)

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QPRTS and PRTS: Planning Strategies for Transferring Family Homes

As an alternative to gifting direct interests in a family home to children, a donor can establish an inter vivos trust for the benefit of children or other family members and make gifts of interests in the property to such a trust during life. There are many different types of trusts that a donor should consider. In this Analysis, Nancy G. Henderson discusses two: a Qualified Personal Residence Trust (QPRT) and a Personal Residence Trust (PRT). She writes:

Personal Residence Trusts (PRTs)

     Although QPRTs are the most favored choice, the Code and applicable regulations also exempt Personal Residence Trusts, or "PRTs" (also sometimes referred to as "Non-Qualified Personal Residence Trusts"), from the special valuation rules of Section 2702. The rules governing PRTs are similar, but not identical to those applicable to QPRTs. Therefore, in some specific instances, PRTs are superior to QPRTs for transferring family homes.

     PRTs are more restrictive than QPRTs in that they can hold only a personal residence (or an interest in a personal residence). They can hold no cash at all with the limited exception of "qualified proceeds" from the involuntary conversion or destruction of the property by fire or casualty. Like a QPRT, any such "qualified proceeds" must be reinvested in a new personal residence within two years of the date of receipt. In addition, the trust document must prohibit the sale of the residence (other than by destruction or involuntary conversion) and must restrict its use to that of the personal residence of the grantor.

     The primary benefit of using a PRT as compared to a QPRT is that the Regulations do not expressly prohibit the commutation of the term and remainder interests in a PRT. Thus, if it becomes desirable to terminate the PRT before the end of its term, such as because it appears that the grantor may not survive the trust term (so long as the grantor's condition is not imminently terminal, which could render the mortality tables inapplicable) or because the proceeds of a casualty or involuntary conversion will not be reinvested in a new residence within two years, the grantor and the remainder beneficiaries should be able to agree to the early termination of a PRT and the division of the trust assets in proportion to the actuarial values of the term and remainder interests. As a result of any such termination, the grantor and the remainder beneficiaries would jointly own the property as tenants in common (or in some other form of joint ownership, such as in an LLC).

(footnotes omitted)

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