FROM NASCAR CONDOMINIUMS TO PRIVATE MAUSOLEUMS: KEEPING THE VACATION HOME IN THE FAMILY - PART 1
FROM NASCAR CONDOMINIUMS TO PRIVATE MAUSOLEUMS: KEEPING THE VACATION HOME IN THE FAMILY - PART 3
By Wendy S. Goffe
V. Transferring the Cabin From the Senior Generation to the Junior Generation.
Once the portions to be set aside for preservation and sale or development (if any) have been identified, the linchpin of the master plan is transferring the cabin to succeeding generations. As indicated above, there are a number of techniques for transferring the cabin to the next generation, some of which are discussed below.
An outright gift to the younger generation (or to a trust for their benefit) will transfer the value of the property and all future appreciation, thereby reducing the taxable estate value of the senior generation. If the gift is given as undivided interests in real property, it may also be possible to apply minority and other discounts to further reduce the value of the gift for gift tax purposes.
Inter vivos gifts, which are tax exclusive, are usually preferable to gifts at death, which are tax inclusive. In other words, at death estate tax is assessed on both the value of a gift and the funds actually used to pay the tax. But during one's life, gift tax is paid with funds not otherwise subject to gift tax. Against this benefit, though, it is necessary to consider that gifts at death are entitled to a full stepped-up tax basis to date-of-death fair market value. I.R.C. §1014(a). Inter vivos gifts, on the other hand, only retain a carry-over basis equal to the basis in the hands of the donor, plus the amount of gift tax paid on the appreciation. I.R.C. §1015. Thus, in a nontaxable estate, it may be best to hold onto property until death to take advantage of the stepped-up basis.
One estate planning technique that can be effective for transferring real estate between family members is the qualified personal residence trust or "QPRT." A QPRT permits a homeowner to make a gift of his or her personal residence (i.e., a primary residence or a vacation home, along with a reasonable amount of surrounding property) to a trust for the benefit of children or other beneficiaries at a reduced gift tax cost. I.R.C. §2702 and Treas. Reg. 25.2702-5(c). The "grantor" (i.e., the homeowner who transfers the residence to the QPRT) is permitted to reserve the right to live in the house for a specified number of years (referred to as a "reserved term of years"). The grantor selects the number of years. During the trust term, the grantor may use of the residence rent-free. Upon expiration of the trust term, the residence is distributed to the remainder beneficiary or beneficiaries (usually the grantor's children), or held in further trust for their benefit.
The value of the gift is the fair market value of the residence at the time of transfer to the QPRT, decreased by the value of the reserved term of years (determined according to IRS tables). Treas. Reg. §25.2702-5. Generally, a longer reserved term produces a correspondingly lower value of the gift for gift tax purposes. Furthermore, where a husband and wife form separate trusts with their respective interests (provided that they are the only owners), a fractional interest discount may also be applied to the value of the gift. The grantor will use a portion of his applicable credit when the transfer is made to the QPRT (or, if the applicable credit has been exhausted, the transfer would be subject to gift tax). At the end of the trust term, the residence passes to or for the benefit of the children with no further gift or estate tax consequences. As a result, all appreciation that occurs during the trust term is "shifted" to the children free of gift or estate tax.
When funding a QPRT, it may be necessary to subdivide the property to carve out the cabin, associated outbuildings, and an appropriate amount of surrounding real property to be transferred via the QPRT. (Treasury Regulation §25.2702-5(c)(2)(ii) provides that, in addition to the personal residence, a QPRT may be funded with "appurtenant structures used by the term holder for residential purposes and adjacent land not in excess of that which is reasonably appropriate for residential purposes (taking into account the residence's size and location).") There are a number of private letter rulings that give guidance as to what the IRS considers a reasonable amount of property to be transferred. See, e.g., PLR 1999-18-049 (Feb. 9, 1999); PLR 2001-26-026 (June 29, 2001); PLR 2006-26-043 (Feb. 23, 2006). Other sources of guidance would be the minimum lot size under local zoning regulations and the parcel sizes of comparable residences in the area.
A QPRT may also be funded with an interest in a foreign personal residence, so long as the non-U.S. jurisdiction recognizes trusts. John F. Meigs & Ryan R. Gager, Using a U.S. Qualified Personal Residence Trust in Cross-Border Planning, 35 Estate Planning 22, 26 (July 2008).
Note that capital gains tax applies to the difference between fair market value and basis (i.e., acquisition cost) of the property, and is paid at the time of sale of the property (when cash is available). In contrast, estate taxes are imposed on the entire fair market value of the property and are due nine months after death, regardless of whether the property has been sold by that time. These factors, plus the fact that the capital gains tax rate usually is lower than the estate tax rate, can make the QPRT an attractive estate planning technique.
It is also important to note that it is not entirely clear whether unrelated parties may establish QPRTs with cotenancy interests in a residence. The issue arises because: (i) the property must have its primary use as the grantor's residence, (ii) the grantor must have the exclusive right of occupancy, and (iii) the property may not be used other than as a residence when the grantor is not there. Treas. Reg. §25.2702-5(b)(2)(iii). Shared occupancy is permissible as long as it is at the sufferance of the grantor. There are no rulings concerning QPRTs established by cotenants who are not also spouses. See Natalie B. Choate, The QPRT Manual, supra at ¶2.3.02. Therefore, the regulations suggest that the exclusive right of occupancy requirement precludes the establishment of QPRTs with cotenancy interests if the cotenants/donors are not also spouses. See John A. Hartog, QPRTs for Co-Tenancy Interests--Do They Work?, 6 California Trusts and Estates Quarterly 4 (Fall 2000).
Where a cotenant with a non-spouse wishes to establish a QPRT, one approach to accomplish the exclusive occupancy requirement is to have that cotenant lease the property from the other co-tenants during the QPRT term. See Natalie B. Choate, The QPRT Manual, supra at ¶2.3.02.
Because of the disadvantages of a QPRT, clients may want to consider some of the alternatives that can be useful, albeit in limited circumstances. One is the split-interest purchase. A split-interest purchase involves the division of the total purchase price: One person contributes an amount equal to his or her life interest value or an interest for a term of years, while the other person contributes an amount equal to the value of the remainder interest following the termination of the term interest.
If the joint purchasers are applicable family members for purposes of I.R.C. §2702, the person acquiring the term interest is treated as acquiring the entire property and then transferring the remainder interest to the other purchaser, and the retained interest (generally a life estate) is valued at zero unless the retained interest constitutes a qualified interest. I.R.C. §2702(c)(2). One way around this might be to have a family member purchase a life interest and a GST trust purchase the remainder, preferably a trust that has been around for other purposes and was not established for this purpose.
Another QPRT alternative is the sale of a remainder interest, which may also be preferable to a QPRT because the seller can retain use of the residence for life, instead of a term of years, rent-free. It also avoids the concern that the grantor might not survive the QPRT term.
This technique is not without risk. Undervaluation of the remainder interest could cause the remainder interest to be brought back into a life tenant's estate under I.R.C. §2036. To withstand scrutiny, the purchasers of the remainder interest should use funds held for some time and not merely received as a gift just prior to the transaction. The sale of a remainder interest also needs to comply with the personal residence trust and qualified personal residence trust regulations set forth in Treas. Regs. §25.2702-5(a). See PLR 200840038 for a roadmap of how to set up this arrangement.
If the residence is sold during the lifetime of the life tenant(s) and the proceeds are not reinvested in a replacement residence, or converted to a qualified annuity trust, the proceeds must be paid to the life tenant. One alternative would be to provide in the purchase and sale agreement of the remainder interest that the sale of the residence during the lifetime of the life tenant(s) is prohibited.
Whereas with a QPRT or life estate, the life estate or primary beneficiary of the trust must pay for maintenance, utilities, insurance, taxes and repairs; where the remainder interest has been sold, the payment for improvements by the life tenant is treated as an additional gift.
Mortgage interest is the responsibility of the life tenant. But, principal payments are considered additional gifts unless the debt is secured by property other than the residence prior to the sale of the remainder or transfer to the QPRT. Or the grantor could retain the obligation and enter into an indemnification agreement with the trust or remainder beneficiary in the event the lender attempts to realize on the security interest.
For many reasons, a trust may not be the preferred arrangement: Duration may be limited by the applicable rule against perpetuities. Where a house is intended to be held in trust for future generations, the trust is often established with an endowment to cover future expenses. As the value of the property increases (which it often does in desirable vacation spots), the endowment may prove to be insufficient to cover expenses. Furthermore, trust terms are more difficult to amend--to adjust to unanticipated changes of circumstance or desires or to add beneficiaries who are not lineal descendants of the settlor--than a tenancy in common or LLC agreement. Similarly, ownership interests cannot be adjusted over time to account for unequal contributions of money or labor. Finally, where a house is place in an irrevocable trust by a parent, if the parent then chooses to remain in the home, he or she must pay fair market rent for that right or the value of the house will be included in his or her estate at death. I.R.C. §2036.
Trusts also raise fiduciary duty issues. Typically, one generation would be the lifetime beneficiaries of the trust. They may also serve as trustees and make certain decisions that would benefit them individually over the interests of the remainder beneficiaries, violating the fiduciary duty of loyalty. These issues may be avoided by using other types of entities, discussed below.
The advantage of a trust for some families is that it is a familiar arrangement already because of other aspects of their estate planning.
The following drafting suggestions should be considered to avoid inclusion of the trust property in the estate of the grantor under I.R.C. §§2036-2038 (adapted from Alexandra T. Breed & Rose A. Costello, Camps, Compounds and Cottages: How to Keep Them in the Family, Tax Consequences for Family Compound Planning, New Hampshire Bar Association 20th Annual Tax Forum (Nov. 15, 2002)):
The senior generation may consider using a revocable trust to transfer ownership of the cabin at a later date. A revocable trust offers the senior generation an opportunity to plan for the management of the cabin, without making those plans final because the grantor or grantors retain the right to revoke the trust.
Typically, the parents would serve as the initial trustees, and they would name their successors, should they become unable to serve, or simply choose to resign. Upon the death of the grantor or grantors, the trust would become irrevocable and either could continue as an irrevocable trust for the next generation, or it could terminate and distribute its assets to named beneficiaries pursuant to its terms.
For a senior generation starting to plan for transfer of the cabin, but not willing to make those plans irrevocable, the revocable trust is a useful first step.
Formation of a family LLC may provide a useful vehicle for transferring a cabin to younger generations. Consideration must be given to avoiding having the entity disregarded for lack of a business purpose. There are a number of legitimate business purposes that may support the use of an entity in the family LLC context, including facilitating the orderly management of the property and the actual operation of a business, such as rental of the cabin.
The transfer of membership interests must occur within the framework of the federal gift tax law as annual exclusion gifts or gifts using part of the grantor's lifetime gift tax exemption amount.
Because of the discounts normally available for minority interests and lack of marketability associated with an LLC, such an entity can permit the transfer of assets at a lower gift tax cost than is generally available with respect to direct transfers. In other words, the LLC permits gift and estate tax savings because the LLC interests are valued at less than a pro rata portion of the underlying assets. Gift taxes are generally lower because of the discounted value of the gifted LLC interests, and the LLC interests held at the death of the older generation often are discounted as well, assuming the older generation has retained less than a majority interest.
The value of a percentage interest gift is established in a two-step process. The first step is to value the company property, i.e., the vacation home (and a bank account or other assets owned in the LLC). This is done by obtaining an appraisal from a competent real estate appraiser. The second step is to value the fractional membership interest that constitutes the gift. This requires a second appraisal by a person qualified to value fractional interests in business entities. The second appraisal takes into account the facts that the asset is a minority interest, it lacks control, and little, if any, market exists for such an interest. The result of the second appraisal is likely to be a discounted value of 20% or more from the proportionate share of the total value. Thus, the membership interests typically can be transferred on a very favorable gift tax basis.
Management of an LLC may be by all of the members voting by percentage interests. Alternatively, one or more managers may govern an LLC. A manager form of LLC permits the transfer of ownership interests to other family members while maintaining control in one or only a few. Thus, Mom and Dad could name themselves as managers but transfer significant ownership interests to their children. As managers, Mom and Dad retain the right to manage the home, make repairs and improvements, and determine its use schedule, and they may give significant portions of the value of the home to the next generation.
In addition to the gift or estate tax benefits, gifts of LLC interests over time provide for the gradual and orderly transfer of responsibility and management. At the same time, the senior family members may retain significant control over management by naming themselves as managers of the LLC. The LLC agreement may also contain transfer restrictions to prevent a sale to an outside party without unanimous consent of the members.
Unlike trusts in most states, LLCs can have perpetual existence. The controlling documents are much easier to amend than a trust agreement. It is possible to alter LLC ownership, whereas it is not usually an option with trusts. But because the LLC operating agreement may be terminated if all of the members agree, there may be less long-term certainty than the senior generation would like.
An LLC can protect the underlying assets of the LLC from the claims of creditors in the event of a lawsuit, the bankruptcy of a member, court judgment, a tax lien, or from claims of a non-family member spouse in the event of divorce. The LLC also offers the added advantage of limited liability for its members, even if all of the members are involved in management.
Families must consider the effect of I.R.C. §2036, which applies to the transfer of property, except in an arm's-length transaction, where the transferor retains the right to enjoyment or use of the property. In this case, the value of the property transferred would be included in the estate of the transferor, and the entity would be disregarded for estate tax purposes. Accordingly, it is important that family members pay rent to the LLC for the personal use of the cabin based on the applicable fair market rent, and accurate records be kept, to avoid having the LLC disregarded for estate tax purposes.
Where the senior generation retains management control of the LLC and the right to use the cabin, even where fair market rent is paid, the benefit will be closely scrutinized by the IRS.
Under all circumstances, LLC formalities should be followed. This includes timely completion of all required state and local filings and tax returns, holding regular meetings of the members and documenting the decisions made, and preparing resolutions authorizing significant transactions as required by the LLC agreement.
The main disadvantage of the LLC is the loss of the exclusion of capital gain on sale of the property under I.R.C. §121, upon sale of the property. This exclusion is not available if the cabin is sold as an asset of an entity such as an LLC. (The Taxpayer Relief Act of 1997, Pub.L. No. 105-34, 111 Stat. 788, amended I.R.C. §121 (formerly providing a one-time exclusion of gain from sale of a principal residence by an individual who has attained age 55) and permits exclusion of up to $250,000 of gain by an individual or $500,000 by a married couple on the sale or exchange of a principal residence if the property was a principal residence for two of the last five years. For spouses, only one spouse must meet the ownership requirement, but both must meet the use requirement. I.R.C. §121(b)(2)(A). Any depreciation claimed with respect to the home after May 6, 1997, will reduce the gain eligible for the exclusion. I.R.C. §121(d)(6). This portion of the gain is taxed at the maximum applicable long-term capital gain rate.)
Finally, it is important to note that the vacation home income tax rules of I.R.C. §280A, which provide for the allocation of expenses attributable to a residence between personal and business use, may apply to LLCs holding a family cabin. The application of I.R.C. §280A is not likely to be significant enough to drive the use of a vacation home by a family. But, the consequences should be kept in mind when individuals are able to adjust their usage for income tax purposes.
If a vacation home is rented for less than 15 days during the year, the rental income does not need to be reported, but no offsetting deductions may be taken either. I.R.C. §280A(g). A vacation home is treated as a residence if personal use exceeds the greater of (i) 14 days, or (ii) 10% of the number of days the property is rented to non-family members at fair market rent. I.R.C. §280A(d)(1). In this case, the rental and personal portions of income and expenses are treated as follows:
If the taxpayer does not rent out the residence at any time during a taxable year, that residence may be treated as a residence for such taxable year whether or not it is actually used by the taxpayer. I.R.C. §163(h)(4)(A)(iii). In other words, a taxpayer may have their actual residence, plus one additional residence for income tax purposes.
Even where the LLC members pay fair market rent for use of the cabin, unless the property is also rented to non-LLC members at fair market rent, no deductions may be taken on the partnership income tax return other than for taxes and interest. (Prop. Treas. Reg. §1.280A-1(e)(5), 48 Fed. Reg. 33320-01 (July 21, 1983), further limits the ability to take deductions to situations in which the LLC rents to a member as that member's principal residence, which isn't likely to be the case with the vacation home.)
A vacation property can be treated primarily as a rental for a year in which personal use does not exceed: (i) 14 days, or (ii) 10% of the number of days the property is rented to non-family members at fair market rent. In this case, the owner's deductions are restricted by the passive loss rules of I.R.C. §469 and not by the vacation home rules described above.
For cabin owners who are able to limit or maximize the number of days vacation property is used versus rented, there are some planning opportunities. If the cabin owner's adjusted gross income is less than $100,000, he or she may want to limit use to have the property qualify as a rental so that up to $25,000 of rental losses may be deducted against other income. I.R.C. §469(i)(2). On the other hand, if the cabin owner's adjusted gross income is over $150,000, the $25,000 passive loss deduction is totally phased out. I.R.C. §469(i)(3). In this case, the cabin owner would be better off having the vacation property qualify as a residence to preserve the mortgage interest and real estate tax deductions.
In Rev. Proc. 2008-16, 2008-10 I.R.B. 547 (Feb. 15, 2008), the IRS announced a safe harbor by which a taxpayer may defer taxes on a vacation home through a Section 1031 exchange. See Bradley T. Borden & Alex Hamrick, Like-Kind Exchanges of Personal-Use Residences, 119 Tax Notes 1253 (June 23, 2008) for a thorough discussion of this Revenue Procedure.
A vacation home or family cabin that which is not used as rental property, will not qualify for an exchange. Under I.R.C. §280A, a use test is imposed to determine if property is used as a rental on a year-by-year basis. The property is used primarily for personal use if the owner's use exceeds 14 days or 10% of the total rental days, and the property is rented for at least one day during the year. If the owner does not use the property for more than 14 days or less than 10% of the rental days during the year, then the property can qualify for §1031 treatment.
The safe harbor provides that a vacation home to qualify for a 1031 exchange if the following conditions are met:
LLCs can be used to "freeze" the value of the property interests retained by the senior generation when other interests are transferred. This type of transaction transfers a property interest that is not likely to appreciate to the senior generation, while transferring an interest in the same property that is likely to appreciate to descendants, either simultaneously or shortly after the first transfer. (Chapter 14 of the Code and the corresponding regulations impose detailed restrictions on how LLC interests may be structured to ensure that appropriate value is attributed to the senior family members' interests when they have transferred LLC interests to younger family members. Treas. Reg. §25.2701.) A discussion of estate freezes is beyond the scope of this paper, but it is a useful planning tool to consider in connection with structuring an LLC that is intended to be used for gifting.
In addition to the transfer techniques discussed above, property can be sold by the senior generation to members of the next generation. Such a sale should eliminate from the estate of the senior family member any appreciation in value of the property. However, the selling/senior generation will receive the sales proceeds, which will be subject to capital gains tax. Eventually, the proceeds and its further appreciation will also be subject to estate tax if not spent or given away prior to death.
It is recommended that an appraisal be obtained to avoid having any portion of the transaction treated as a gift.
Sales can be structured in any of the following ways:
I.R.C. §7872 imputes interest for loans with an interest rate less than the applicable federal rate ("AFR"). There is a risk that the IRS may assert that the difference between the AFR and the stated rate on the promissory note generates both income and gift tax consequences for the seller. The IRS will impute taxable income to the seller and impute a taxable gift received from the seller by the purchaser in the amount of this difference. See Benjamin N. Feder, The Promissory Note Problem, 142 Trusts & Estates 10, 11 (Jan. 2003).
The self-canceling installment sale employs the use of a promissory note that, by its express terms, expires upon the death of the payee. See Edward P. Wojnaroski, 805-2nd Tax Mgmt. (BNA), Private Annuities and Self-Canceling Installment Notes (2002). As a result, the unpaid balance of the note is reduced to zero at the death of the payee prior to payment in full. Given the uncertainty of collecting all of the payments, the purchase price should reflect "full and adequate consideration," which includes a built-in premium to pay for the risk of not collecting the entire sum. While the IRS has accepted the use of self-canceling installment notes, there is minimal guidance on setting the amount of the risk premium. Estate of Moss v. Commissioner, 74 T.C. 1239 (1980) acq. in result, 1981-1 C.B. 2 and Gen. Couns. Mem. 39,503 (May 7, 1986). Because the seller's life expectancy should exceed the payment period, the premium need not be excessively large. Usually, the seller's life expectancy is determined using particular tables. (The table used in this instance is Table 72 as required under Treas. Reg. §1.72.) However, if the seller's actual life expectancy is reduced for known reasons, the risk premium should be increased accordingly. Failure to do so may result in the IRS asserting that the sale is a disguised gift.
A private annuity is a contract that provides for specified payments to the named annuitant during the annuitant's lifetime. Typically, one party agrees to transfer property to an individual in return for the right to an annuity payment for life. See Stephan R. Leimberg & Leo C. Hodges, The Income Tax and Estate Planning Advantages of Private Annuities, 33 Estate Planning 3 (Feb. 2006), and Stephan R. Leimberg and Albert E. Gibbons, Annuities and Estate Planning, 29 Estate Planning 360, 363 (2002). A private annuity is similar to the self-canceling installment note, except that the payments never cease so long as the annuitant is alive, even if the annuitant outlives his or her life expectancy. The advantage of the private annuity is that the annuity amount can be determined from IRS valuation tables, eliminating the speculation as to the amount of the periodic payments to be made. However, under newly released regulations, the amount realized attributable to the annuity contract--the fair market value of the contract--is immediately subject to capital gains tax, making it a much less attractive tool. (See Exchanges of Property for an Annuity, 71 Fed. Reg. 61441 (proposed Oct. 18, 2006), effective for annuities entered into on or after October 18, 2006. Payments received on contracts predating October 18, 2006, are grandfathered, as are arrangements completed before April 18, 2007, if unsecured, purchased by an individual, and not resold within 2 years of purchase. Prop. Treas. Reg. §1.1001(j).) Because a private annuity is essentially a sale in return for a promise to pay--unlike promissory notes used with installment sales--private annuities cannot be secured, putting the annuitant at risk that the buyer may default. Because of the disadvantages of the private annuity, the installment sale and self-canceling installment are likely to be more appealing alternatives to most families.
FROM NASCAR CONDOMINIUMS TO PRIVATE MAUSOLEUMS: KEEPING THE VACATION HOME IN THE FAMILY - PART 3
By Wendy S. Goffe
V. Transferring the Cabin From the Senior Generation to the Junior Generation.
Once the portions to be set aside for preservation and sale or development (if any) have been identified, the linchpin of the master plan is transferring the cabin to succeeding generations. As indicated above, there are a number of techniques for transferring the cabin to the next generation, some of which are discussed below.
A. Outright Gifts.
An outright gift to the younger generation (or to a trust for their benefit) will transfer the value of the property and all future appreciation, thereby reducing the taxable estate value of the senior generation. If the gift is given as undivided interests in real property, it may also be possible to apply minority and other discounts to further reduce the value of the gift for gift tax purposes.
Inter vivos gifts, which are tax exclusive, are usually preferable to gifts at death, which are tax inclusive. In other words, at death estate tax is assessed on both the value of a gift and the funds actually used to pay the tax. But during one's life, gift tax is paid with funds not otherwise subject to gift tax. Against this benefit, though, it is necessary to consider that gifts at death are entitled to a full stepped-up tax basis to date-of-death fair market value. I.R.C. §1014(a). Inter vivos gifts, on the other hand, only retain a carry-over basis equal to the basis in the hands of the donor, plus the amount of gift tax paid on the appreciation. I.R.C. §1015. Thus, in a nontaxable estate, it may be best to hold onto property until death to take advantage of the stepped-up basis.
B. Qualified Personal Residence Trusts.
One estate planning technique that can be effective for transferring real estate between family members is the qualified personal residence trust or "QPRT." A QPRT permits a homeowner to make a gift of his or her personal residence (i.e., a primary residence or a vacation home, along with a reasonable amount of surrounding property) to a trust for the benefit of children or other beneficiaries at a reduced gift tax cost. I.R.C. §2702 and Treas. Reg. 25.2702-5(c). The "grantor" (i.e., the homeowner who transfers the residence to the QPRT) is permitted to reserve the right to live in the house for a specified number of years (referred to as a "reserved term of years"). The grantor selects the number of years. During the trust term, the grantor may use of the residence rent-free. Upon expiration of the trust term, the residence is distributed to the remainder beneficiary or beneficiaries (usually the grantor's children), or held in further trust for their benefit.
The value of the gift is the fair market value of the residence at the time of transfer to the QPRT, decreased by the value of the reserved term of years (determined according to IRS tables). Treas. Reg. §25.2702-5. Generally, a longer reserved term produces a correspondingly lower value of the gift for gift tax purposes. Furthermore, where a husband and wife form separate trusts with their respective interests (provided that they are the only owners), a fractional interest discount may also be applied to the value of the gift. The grantor will use a portion of his applicable credit when the transfer is made to the QPRT (or, if the applicable credit has been exhausted, the transfer would be subject to gift tax). At the end of the trust term, the residence passes to or for the benefit of the children with no further gift or estate tax consequences. As a result, all appreciation that occurs during the trust term is "shifted" to the children free of gift or estate tax.
When funding a QPRT, it may be necessary to subdivide the property to carve out the cabin, associated outbuildings, and an appropriate amount of surrounding real property to be transferred via the QPRT. (Treasury Regulation §25.2702-5(c)(2)(ii) provides that, in addition to the personal residence, a QPRT may be funded with "appurtenant structures used by the term holder for residential purposes and adjacent land not in excess of that which is reasonably appropriate for residential purposes (taking into account the residence's size and location).") There are a number of private letter rulings that give guidance as to what the IRS considers a reasonable amount of property to be transferred. See, e.g., PLR 1999-18-049 (Feb. 9, 1999); PLR 2001-26-026 (June 29, 2001); PLR 2006-26-043 (Feb. 23, 2006). Other sources of guidance would be the minimum lot size under local zoning regulations and the parcel sizes of comparable residences in the area.
A QPRT may also be funded with an interest in a foreign personal residence, so long as the non-U.S. jurisdiction recognizes trusts. John F. Meigs & Ryan R. Gager, Using a U.S. Qualified Personal Residence Trust in Cross-Border Planning, 35 Estate Planning 22, 26 (July 2008).
There are the following drawbacks to the QPRT:1. Drawbacks to the QPRT.
a. If the grantor wishes to continue to occupy the residence at the end of the reserved term, the grantor must pay fair market rent to the remainder beneficiaries. If a home has appreciated considerably over the term of the QPRT, fair market rent may pose a financial burden. The rental payments would represent taxable income to the children. However, the amount of rent paid by the grantor would be removed from the (taxable) estate, which represents further overall tax savings for those parents interested in reducing potential estate tax liability.
b. The tax advantages of a QPRT also depend on the grantor surviving the trust term. If the grantor fails to survive the term of years, the entire value of the trust's interest in the residence at the grantor's death will be included in the grantor's estate for estate tax purposes. Therefore, the estate and gift tax advantages will be lost, but the effect will generally be the same as if the QPRT had not been established.
c. If a residence were transferred using a QPRT, it would not be entitled to the step-up in basis that would otherwise be available at the time of the transferor's death. I.R.C. §1014(a). In some circumstances, it may be advantageous to transfer the residence at death (e.g., where the parents' estates are not expected to be taxable even if the residence is included, or when the property is expected to be sold by the younger generation upon the death of the senior generation).
d. A QPRT should not be used to make gifts to grandchildren because of the estate tax inclusion period. (The estate tax inclusion period is the period of time following a transfer during which the value of the transferred property would be included in the transferor's estate if the transferor dies. The transferor's GST exemption cannot be allocated to the value of the transferred property until the estate tax inclusion period terminates. I.R.C. §2642(f)(3).) The grantor's GST tax exemption cannot be allocated to the gift until the expiration of the term of years, and it must be allocated to the entire value of the gift at that time. I.R.C. §2642(f).
e. Generally, property subject to indebtedness should not be transferred to a QPRT. Future payments toward principal would be treated as additional gifts to the QPRT in the year paid (however, interest only payments would not be treated as additional gifts). See John F. Meigs & Ryan R. Gager, Using a U.S. Qualified Personal Residence Trust in Cross-Border Planning, 35 Estate Planning 22, 24 (July 2008) citing Natalie B. Choate, The QPRT Manual: The Estate Planner's Guide to Qualified Personal Residence Trusts ¶2.7 (Ataxplan Publications 2004) (hereinafter "Natalie B. Choate, The QPRT Manual").
When determining if a QPRT is appropriate for any client, balance the likely estate tax savings (i.e., the highest marginal estate tax rate applicable to the dollars in question, multiplied by the value of the residence that is being removed from the taxable estate) against the capital gains tax rate (generally, 15% under current law) that will be applied if the property is sold.2. Additional Considerations.
Note that capital gains tax applies to the difference between fair market value and basis (i.e., acquisition cost) of the property, and is paid at the time of sale of the property (when cash is available). In contrast, estate taxes are imposed on the entire fair market value of the property and are due nine months after death, regardless of whether the property has been sold by that time. These factors, plus the fact that the capital gains tax rate usually is lower than the estate tax rate, can make the QPRT an attractive estate planning technique.
It is also important to note that it is not entirely clear whether unrelated parties may establish QPRTs with cotenancy interests in a residence. The issue arises because: (i) the property must have its primary use as the grantor's residence, (ii) the grantor must have the exclusive right of occupancy, and (iii) the property may not be used other than as a residence when the grantor is not there. Treas. Reg. §25.2702-5(b)(2)(iii). Shared occupancy is permissible as long as it is at the sufferance of the grantor. There are no rulings concerning QPRTs established by cotenants who are not also spouses. See Natalie B. Choate, The QPRT Manual, supra at ¶2.3.02. Therefore, the regulations suggest that the exclusive right of occupancy requirement precludes the establishment of QPRTs with cotenancy interests if the cotenants/donors are not also spouses. See John A. Hartog, QPRTs for Co-Tenancy Interests--Do They Work?, 6 California Trusts and Estates Quarterly 4 (Fall 2000).
Where a cotenant with a non-spouse wishes to establish a QPRT, one approach to accomplish the exclusive occupancy requirement is to have that cotenant lease the property from the other co-tenants during the QPRT term. See Natalie B. Choate, The QPRT Manual, supra at ¶2.3.02.
C. Split-Interest Purchases.
Because of the disadvantages of a QPRT, clients may want to consider some of the alternatives that can be useful, albeit in limited circumstances. One is the split-interest purchase. A split-interest purchase involves the division of the total purchase price: One person contributes an amount equal to his or her life interest value or an interest for a term of years, while the other person contributes an amount equal to the value of the remainder interest following the termination of the term interest.
If the joint purchasers are applicable family members for purposes of I.R.C. §2702, the person acquiring the term interest is treated as acquiring the entire property and then transferring the remainder interest to the other purchaser, and the retained interest (generally a life estate) is valued at zero unless the retained interest constitutes a qualified interest. I.R.C. §2702(c)(2). One way around this might be to have a family member purchase a life interest and a GST trust purchase the remainder, preferably a trust that has been around for other purposes and was not established for this purpose.
D. Sale of a remainder interest.
Another QPRT alternative is the sale of a remainder interest, which may also be preferable to a QPRT because the seller can retain use of the residence for life, instead of a term of years, rent-free. It also avoids the concern that the grantor might not survive the QPRT term.
This technique is not without risk. Undervaluation of the remainder interest could cause the remainder interest to be brought back into a life tenant's estate under I.R.C. §2036. To withstand scrutiny, the purchasers of the remainder interest should use funds held for some time and not merely received as a gift just prior to the transaction. The sale of a remainder interest also needs to comply with the personal residence trust and qualified personal residence trust regulations set forth in Treas. Regs. §25.2702-5(a). See PLR 200840038 for a roadmap of how to set up this arrangement.
If the residence is sold during the lifetime of the life tenant(s) and the proceeds are not reinvested in a replacement residence, or converted to a qualified annuity trust, the proceeds must be paid to the life tenant. One alternative would be to provide in the purchase and sale agreement of the remainder interest that the sale of the residence during the lifetime of the life tenant(s) is prohibited.
Whereas with a QPRT or life estate, the life estate or primary beneficiary of the trust must pay for maintenance, utilities, insurance, taxes and repairs; where the remainder interest has been sold, the payment for improvements by the life tenant is treated as an additional gift.
Mortgage interest is the responsibility of the life tenant. But, principal payments are considered additional gifts unless the debt is secured by property other than the residence prior to the sale of the remainder or transfer to the QPRT. Or the grantor could retain the obligation and enter into an indemnification agreement with the trust or remainder beneficiary in the event the lender attempts to realize on the security interest.
E. Other Types of Trusts.
An irrevocable trust (other than a QPRT) owning real estate, which removes the house from the grantor's estate, can serve as a vehicle for gift giving to younger generations during the senior generations' lifetime. The trust can name beneficiaries and grant others the power to expand the number of beneficiaries. The parents can give their children and grandchildren (or others) annual exclusion gifts and/or larger lifetime gifts that consume a portion of their applicable exclusion amount.1. Irrevocable Trusts.
For many reasons, a trust may not be the preferred arrangement: Duration may be limited by the applicable rule against perpetuities. Where a house is intended to be held in trust for future generations, the trust is often established with an endowment to cover future expenses. As the value of the property increases (which it often does in desirable vacation spots), the endowment may prove to be insufficient to cover expenses. Furthermore, trust terms are more difficult to amend--to adjust to unanticipated changes of circumstance or desires or to add beneficiaries who are not lineal descendants of the settlor--than a tenancy in common or LLC agreement. Similarly, ownership interests cannot be adjusted over time to account for unequal contributions of money or labor. Finally, where a house is place in an irrevocable trust by a parent, if the parent then chooses to remain in the home, he or she must pay fair market rent for that right or the value of the house will be included in his or her estate at death. I.R.C. §2036.
Trusts also raise fiduciary duty issues. Typically, one generation would be the lifetime beneficiaries of the trust. They may also serve as trustees and make certain decisions that would benefit them individually over the interests of the remainder beneficiaries, violating the fiduciary duty of loyalty. These issues may be avoided by using other types of entities, discussed below.
The advantage of a trust for some families is that it is a familiar arrangement already because of other aspects of their estate planning.
The following drafting suggestions should be considered to avoid inclusion of the trust property in the estate of the grantor under I.R.C. §§2036-2038 (adapted from Alexandra T. Breed & Rose A. Costello, Camps, Compounds and Cottages: How to Keep Them in the Family, Tax Consequences for Family Compound Planning, New Hampshire Bar Association 20th Annual Tax Forum (Nov. 15, 2002)):
a. To avoid inclusion under I.R.C. §2036, the trust agreement should express the grantor's intent to relinquish possession and enjoyment of the property, the right to any income from the property, and the right to designate who will enjoy or possess the property or income from the property.
b. Also to avoid inclusion under I.R.C. §2036, the trust agreement should state that neither its creation nor the distribution of any income from it shall be deemed to discharge or relieve the grantor from the obligation to support a dependent.
c. To avoid inclusion under I.R.C. §2037, the trust agreement should not permit assets to revert to the grantor under any circumstances.
d. To avoid inclusion under I.R.C. §2038, the trust agreement should be irrevocable and the grantor should not possess any power to amend, revoke, or terminate the trust or any part of it.
2. Revocable Trusts.
The senior generation may consider using a revocable trust to transfer ownership of the cabin at a later date. A revocable trust offers the senior generation an opportunity to plan for the management of the cabin, without making those plans final because the grantor or grantors retain the right to revoke the trust.
Typically, the parents would serve as the initial trustees, and they would name their successors, should they become unable to serve, or simply choose to resign. Upon the death of the grantor or grantors, the trust would become irrevocable and either could continue as an irrevocable trust for the next generation, or it could terminate and distribute its assets to named beneficiaries pursuant to its terms.
For a senior generation starting to plan for transfer of the cabin, but not willing to make those plans irrevocable, the revocable trust is a useful first step.
F. Family Limited Liability Companies.
Formation of a family LLC may provide a useful vehicle for transferring a cabin to younger generations. Consideration must be given to avoiding having the entity disregarded for lack of a business purpose. There are a number of legitimate business purposes that may support the use of an entity in the family LLC context, including facilitating the orderly management of the property and the actual operation of a business, such as rental of the cabin.
1. Transfer of Ownership.
The transfer of membership interests must occur within the framework of the federal gift tax law as annual exclusion gifts or gifts using part of the grantor's lifetime gift tax exemption amount.
Because of the discounts normally available for minority interests and lack of marketability associated with an LLC, such an entity can permit the transfer of assets at a lower gift tax cost than is generally available with respect to direct transfers. In other words, the LLC permits gift and estate tax savings because the LLC interests are valued at less than a pro rata portion of the underlying assets. Gift taxes are generally lower because of the discounted value of the gifted LLC interests, and the LLC interests held at the death of the older generation often are discounted as well, assuming the older generation has retained less than a majority interest.
The value of a percentage interest gift is established in a two-step process. The first step is to value the company property, i.e., the vacation home (and a bank account or other assets owned in the LLC). This is done by obtaining an appraisal from a competent real estate appraiser. The second step is to value the fractional membership interest that constitutes the gift. This requires a second appraisal by a person qualified to value fractional interests in business entities. The second appraisal takes into account the facts that the asset is a minority interest, it lacks control, and little, if any, market exists for such an interest. The result of the second appraisal is likely to be a discounted value of 20% or more from the proportionate share of the total value. Thus, the membership interests typically can be transferred on a very favorable gift tax basis.
2. LLC Management.
Management of an LLC may be by all of the members voting by percentage interests. Alternatively, one or more managers may govern an LLC. A manager form of LLC permits the transfer of ownership interests to other family members while maintaining control in one or only a few. Thus, Mom and Dad could name themselves as managers but transfer significant ownership interests to their children. As managers, Mom and Dad retain the right to manage the home, make repairs and improvements, and determine its use schedule, and they may give significant portions of the value of the home to the next generation.
In addition to the gift or estate tax benefits, gifts of LLC interests over time provide for the gradual and orderly transfer of responsibility and management. At the same time, the senior family members may retain significant control over management by naming themselves as managers of the LLC. The LLC agreement may also contain transfer restrictions to prevent a sale to an outside party without unanimous consent of the members.
Unlike trusts in most states, LLCs can have perpetual existence. The controlling documents are much easier to amend than a trust agreement. It is possible to alter LLC ownership, whereas it is not usually an option with trusts. But because the LLC operating agreement may be terminated if all of the members agree, there may be less long-term certainty than the senior generation would like.
3. Liability Protection.
An LLC can protect the underlying assets of the LLC from the claims of creditors in the event of a lawsuit, the bankruptcy of a member, court judgment, a tax lien, or from claims of a non-family member spouse in the event of divorce. The LLC also offers the added advantage of limited liability for its members, even if all of the members are involved in management.
4. Estate Tax Considerations.
Families must consider the effect of I.R.C. §2036, which applies to the transfer of property, except in an arm's-length transaction, where the transferor retains the right to enjoyment or use of the property. In this case, the value of the property transferred would be included in the estate of the transferor, and the entity would be disregarded for estate tax purposes. Accordingly, it is important that family members pay rent to the LLC for the personal use of the cabin based on the applicable fair market rent, and accurate records be kept, to avoid having the LLC disregarded for estate tax purposes.
Where the senior generation retains management control of the LLC and the right to use the cabin, even where fair market rent is paid, the benefit will be closely scrutinized by the IRS.
Under all circumstances, LLC formalities should be followed. This includes timely completion of all required state and local filings and tax returns, holding regular meetings of the members and documenting the decisions made, and preparing resolutions authorizing significant transactions as required by the LLC agreement.
5. Income Tax Considerations.
a. I.R.C. §121 -- Exclusion of Capital Gain Upon Sale.
The main disadvantage of the LLC is the loss of the exclusion of capital gain on sale of the property under I.R.C. §121, upon sale of the property. This exclusion is not available if the cabin is sold as an asset of an entity such as an LLC. (The Taxpayer Relief Act of 1997, Pub.L. No. 105-34, 111 Stat. 788, amended I.R.C. §121 (formerly providing a one-time exclusion of gain from sale of a principal residence by an individual who has attained age 55) and permits exclusion of up to $250,000 of gain by an individual or $500,000 by a married couple on the sale or exchange of a principal residence if the property was a principal residence for two of the last five years. For spouses, only one spouse must meet the ownership requirement, but both must meet the use requirement. I.R.C. §121(b)(2)(A). Any depreciation claimed with respect to the home after May 6, 1997, will reduce the gain eligible for the exclusion. I.R.C. §121(d)(6). This portion of the gain is taxed at the maximum applicable long-term capital gain rate.)
b. I.R.C. §280A: Vacation Home Income Tax Rules.
Finally, it is important to note that the vacation home income tax rules of I.R.C. §280A, which provide for the allocation of expenses attributable to a residence between personal and business use, may apply to LLCs holding a family cabin. The application of I.R.C. §280A is not likely to be significant enough to drive the use of a vacation home by a family. But, the consequences should be kept in mind when individuals are able to adjust their usage for income tax purposes.
If a vacation home is rented for less than 15 days during the year, the rental income does not need to be reported, but no offsetting deductions may be taken either. I.R.C. §280A(g). A vacation home is treated as a residence if personal use exceeds the greater of (i) 14 days, or (ii) 10% of the number of days the property is rented to non-family members at fair market rent. I.R.C. §280A(d)(1). In this case, the rental and personal portions of income and expenses are treated as follows:
i. Rental Portion. Rental income may be offset by rent-related deductions. An owner may also claim a depreciation deduction. But, I.R.C. §280A(c)(5) limits the deductions that may be taken currently. Excess deductions may be carried forward.
ii. Personal Portion. The mortgage interest and real estate taxes allocable to personal use are deductible.
If the taxpayer does not rent out the residence at any time during a taxable year, that residence may be treated as a residence for such taxable year whether or not it is actually used by the taxpayer. I.R.C. §163(h)(4)(A)(iii). In other words, a taxpayer may have their actual residence, plus one additional residence for income tax purposes.
Even where the LLC members pay fair market rent for use of the cabin, unless the property is also rented to non-LLC members at fair market rent, no deductions may be taken on the partnership income tax return other than for taxes and interest. (Prop. Treas. Reg. §1.280A-1(e)(5), 48 Fed. Reg. 33320-01 (July 21, 1983), further limits the ability to take deductions to situations in which the LLC rents to a member as that member's principal residence, which isn't likely to be the case with the vacation home.)
A vacation property can be treated primarily as a rental for a year in which personal use does not exceed: (i) 14 days, or (ii) 10% of the number of days the property is rented to non-family members at fair market rent. In this case, the owner's deductions are restricted by the passive loss rules of I.R.C. §469 and not by the vacation home rules described above.
For cabin owners who are able to limit or maximize the number of days vacation property is used versus rented, there are some planning opportunities. If the cabin owner's adjusted gross income is less than $100,000, he or she may want to limit use to have the property qualify as a rental so that up to $25,000 of rental losses may be deducted against other income. I.R.C. §469(i)(2). On the other hand, if the cabin owner's adjusted gross income is over $150,000, the $25,000 passive loss deduction is totally phased out. I.R.C. §469(i)(3). In this case, the cabin owner would be better off having the vacation property qualify as a residence to preserve the mortgage interest and real estate tax deductions.
c. 1031 Exchange of a Vacation Home.
In Rev. Proc. 2008-16, 2008-10 I.R.B. 547 (Feb. 15, 2008), the IRS announced a safe harbor by which a taxpayer may defer taxes on a vacation home through a Section 1031 exchange. See Bradley T. Borden & Alex Hamrick, Like-Kind Exchanges of Personal-Use Residences, 119 Tax Notes 1253 (June 23, 2008) for a thorough discussion of this Revenue Procedure.
A vacation home or family cabin that which is not used as rental property, will not qualify for an exchange. Under I.R.C. §280A, a use test is imposed to determine if property is used as a rental on a year-by-year basis. The property is used primarily for personal use if the owner's use exceeds 14 days or 10% of the total rental days, and the property is rented for at least one day during the year. If the owner does not use the property for more than 14 days or less than 10% of the rental days during the year, then the property can qualify for §1031 treatment.
The safe harbor provides that a vacation home to qualify for a 1031 exchange if the following conditions are met:
i. With respect to the relinquished property:
(1) The taxpayer has owned it for at least 24 months prior to the exchange and in each of the two 12-month periods prior to the exchange the property was rented at fair value for 14 days or more, and
(2) The taxpayer's personal use of the property during the prior two 12-month periods did not exceed the greater of 14 days or-10% of the number of days that the property was rented at a fair rental rate.
ii. With respect to the replacement property:
Because it is a safe harbor, not following the rules does not preclude a qualifying exchange.(1) It is held for at least 24 months after the exchange, and
(2) The personal use and rental for the two 12 subsequent 12 month periods meet the same 14 day/10% test that apply to the relinquished property given up.
6. Using LLCs to Accomplish an Estate Freeze.
LLCs can be used to "freeze" the value of the property interests retained by the senior generation when other interests are transferred. This type of transaction transfers a property interest that is not likely to appreciate to the senior generation, while transferring an interest in the same property that is likely to appreciate to descendants, either simultaneously or shortly after the first transfer. (Chapter 14 of the Code and the corresponding regulations impose detailed restrictions on how LLC interests may be structured to ensure that appropriate value is attributed to the senior family members' interests when they have transferred LLC interests to younger family members. Treas. Reg. §25.2701.) A discussion of estate freezes is beyond the scope of this paper, but it is a useful planning tool to consider in connection with structuring an LLC that is intended to be used for gifting.
G. Sales to Family Members.
In addition to the transfer techniques discussed above, property can be sold by the senior generation to members of the next generation. Such a sale should eliminate from the estate of the senior family member any appreciation in value of the property. However, the selling/senior generation will receive the sales proceeds, which will be subject to capital gains tax. Eventually, the proceeds and its further appreciation will also be subject to estate tax if not spent or given away prior to death.
It is recommended that an appraisal be obtained to avoid having any portion of the transaction treated as a gift.
Sales can be structured in any of the following ways:
1. An Outright Sale for Cash.
2. An Installment Sale under I.R.C. §453(b).
I.R.C. §7872 imputes interest for loans with an interest rate less than the applicable federal rate ("AFR"). There is a risk that the IRS may assert that the difference between the AFR and the stated rate on the promissory note generates both income and gift tax consequences for the seller. The IRS will impute taxable income to the seller and impute a taxable gift received from the seller by the purchaser in the amount of this difference. See Benjamin N. Feder, The Promissory Note Problem, 142 Trusts & Estates 10, 11 (Jan. 2003).
3. Sale In Exchange for a Self-Canceling Installment Note.
The self-canceling installment sale employs the use of a promissory note that, by its express terms, expires upon the death of the payee. See Edward P. Wojnaroski, 805-2nd Tax Mgmt. (BNA), Private Annuities and Self-Canceling Installment Notes (2002). As a result, the unpaid balance of the note is reduced to zero at the death of the payee prior to payment in full. Given the uncertainty of collecting all of the payments, the purchase price should reflect "full and adequate consideration," which includes a built-in premium to pay for the risk of not collecting the entire sum. While the IRS has accepted the use of self-canceling installment notes, there is minimal guidance on setting the amount of the risk premium. Estate of Moss v. Commissioner, 74 T.C. 1239 (1980) acq. in result, 1981-1 C.B. 2 and Gen. Couns. Mem. 39,503 (May 7, 1986). Because the seller's life expectancy should exceed the payment period, the premium need not be excessively large. Usually, the seller's life expectancy is determined using particular tables. (The table used in this instance is Table 72 as required under Treas. Reg. §1.72.) However, if the seller's actual life expectancy is reduced for known reasons, the risk premium should be increased accordingly. Failure to do so may result in the IRS asserting that the sale is a disguised gift.
4. Sale In Exchange for a Private Annuity.
A private annuity is a contract that provides for specified payments to the named annuitant during the annuitant's lifetime. Typically, one party agrees to transfer property to an individual in return for the right to an annuity payment for life. See Stephan R. Leimberg & Leo C. Hodges, The Income Tax and Estate Planning Advantages of Private Annuities, 33 Estate Planning 3 (Feb. 2006), and Stephan R. Leimberg and Albert E. Gibbons, Annuities and Estate Planning, 29 Estate Planning 360, 363 (2002). A private annuity is similar to the self-canceling installment note, except that the payments never cease so long as the annuitant is alive, even if the annuitant outlives his or her life expectancy. The advantage of the private annuity is that the annuity amount can be determined from IRS valuation tables, eliminating the speculation as to the amount of the periodic payments to be made. However, under newly released regulations, the amount realized attributable to the annuity contract--the fair market value of the contract--is immediately subject to capital gains tax, making it a much less attractive tool. (See Exchanges of Property for an Annuity, 71 Fed. Reg. 61441 (proposed Oct. 18, 2006), effective for annuities entered into on or after October 18, 2006. Payments received on contracts predating October 18, 2006, are grandfathered, as are arrangements completed before April 18, 2007, if unsecured, purchased by an individual, and not resold within 2 years of purchase. Prop. Treas. Reg. §1.1001(j).) Because a private annuity is essentially a sale in return for a promise to pay--unlike promissory notes used with installment sales--private annuities cannot be secured, putting the annuitant at risk that the buyer may default. Because of the disadvantages of the private annuity, the installment sale and self-canceling installment are likely to be more appealing alternatives to most families.
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