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Estate Planning: Advanced Estate Planning


A special kind of irrevocable trust can be used to transfer your residence to your children at a significantly reduced gift tax cost and with no estate tax, yet allow you to continue to live in the residence for as long as you wish. This special type of trust is known as a qualified personal residence trust (QPRT). (QPRTs are sometimes also referred to as “residence GRITs” or “house GRITs”.) Here's how it works.

During your lifetime, you transfer your residence to the trustee, who (if state law permits) can be yourself. The trustee must allow you to continue to use the residence rent-free for a fixed number of years specified in the trust instrument (the “fixed term”), which should be a term you are likely to survive. During the fixed term, you will continue to pay mortgage expenses, real estate taxes, insurance, and expenses for maintenance and repairs, and will continue to deduct mortgage interest and real estate taxes on your individual income tax return. When the fixed term ends, the residence is distributed to your children, or remains in further trust for them.

Even after the fixed term ends, you can continue to use the residence in one of two ways. First, rather than immediately distributing the residence to your children, the residence can be retained in trust for your spouse's lifetime, thus assuring that the residence is available to you. Second, you can enter into a lease with your children which will allow you to live in the residence for as long as you wish. (If you do so, however, you must pay fair market value rent to your children after the fixed term ends in order to keep the residence from being subject to estate tax on your death.)

Although your transfer of the residence to the trust is a taxable gift, you are allowed to subtract, from the fair market value of the residence, the value of your right to live rent-free in the residence for the fixed term. Thus, the amount of the taxable gift will usually be substantially less than the fair market value of the residence. If the amount of the gift is less than your available exclusion from the gift tax ($1,000,000, reduced by amounts allowed for gifts in previous years), no gift tax will be due as a result of your gift to the trust.

If you survive the fixed term of the QPRT, the value of the residence will not be included in your estate for estate tax purposes. Even if you don't survive the fixed term, the estate tax consequences will be no worse than they would have been if you hadn't created the trust in the first place. In other words, from a tax point of view, there's no potential downside to a QPRT.
A QPRT is an effective way to remove a residence's value from your estate at a greatly reduced gift tax cost


How to make sure the life insurance benefits your family will receive after your death avoid the federal estate tax. This is an important issue because, once the federal estate tax applies, the rates are high (beginning at 37% and going up to 55%; though the top rate drops to 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007, 2008, and 2009).

Insurance on your life will be included in your taxable estate if either:

    1. Your estate is the beneficiary of the insurance proceeds, or
    2. You possessed certain economic ownership rights (“incidents of ownership”) in the policy at your death (or within three years of your death).

Avoiding the first situation is easy: just make sure your estate is not designated as beneficiary of the policy.

The second rule is more complex. Clearly, if you are the owner of the policy, the proceeds are included in your estate regardless of who the beneficiary is. However, simply having someone else possess legal title to the policy will not prevent this result if you keep so-called “incidents of ownership” in the policy. Rights that, if held by you, will cause the proceeds to be taxed in your estate include:

  • the right to change beneficiaries,
  • the right to assign the policy (or to revoke an assignment),
  • the right to pledge the policy as security for a loan,
  • the right to borrow against the policy's cash surrender value, and
  • the right to surrender or cancel the policy

Keep in mind that merely having any of the above powers will cause the proceeds to be taxed in your estate even if you never exercise the power.

Buy-sell agreements - Life insurance obtained to fund a buy-sell agreement for a business interest under a “cross-purchase” arrangement will not be taxed in your estate (unless the estate is named as beneficiary). For example, say Al and Bob are partners who agree that the partnership interest of the first of them to die will be bought by the surviving partner. To fund these obligations, Al buys a life insurance policy on Bob's life. Al pays all the premiums, retains all incidents of ownership, and names himself beneficiary. Bob does the same regarding Al. When the first partner dies, the insurance proceeds are not taxed in his estate.

Life insurance trusts - A life insurance trust is an effective vehicle that can be set up to keep life insurance proceeds from being taxed in the insured's estate. Typically, the policy is transferred to the trust along with assets that can be used to pay future premiums. Alternatively, the trust buys the insurance itself with funds contributed by the insured. As long as the trust agreement gives the insured none of the ownership rights described above, the proceeds will not be included in his estate.

The three-year rule - If you are considering setting up a life insurance trust with a policy you own currently or simply assigning away your ownership rights in such a policy, please call me as soon as you reasonably can to effect these moves. Unless you live for at least three years after these steps are taken, the proceeds will be taxed in your estate. For policies in which you never held incidents of ownership, the three-year rule doesn't apply.

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