tax planning

With Estate Taxes on Sale Now, You Snooze, You Lose!

You may want to consider gifting your home — or maybe a fractional interest in it — as well as using an irrevocable trust before it’s too late.

As you know, the Trump tax cuts (2017 Tax Cuts and Jobs Act) created unprecedented opportunities for individuals and families to transfer their legacies in a tax-efficient manner. These cuts doubled the estate, gift and generation-skipping transfer tax exemption amounts from previous levels.

While the federal estate and gift tax exemption amount is currently $11.58 million per person (indexed for inflation), the increased exemptions are scheduled to remain in place only until Dec. 31, 2025, after which they are set to decrease to $5 million per person, indexed for inflation.

However, depending upon the outcome of the upcoming November 2020 election, the elevated exemption levels may be cut much sooner. This would mean that these once-in-a-lifetime wealth-transfer planning opportunities may soon disappear.  For this reason, it is more crucial than ever for you and your family to consider utilizing your elevated gift tax exemption before year’s end. 

Why Some Folks Have Put Off Their Gifting Assets

Because taking advantage of the elevated gift tax exemption amount generally requires transferring, or “gifting” assets out of one’s taxable estate, there is a practical reluctance to do so. This is due to concerns about not having sufficient income to live on for the remainder of one’s lifetime.

Some may be especially hesitant to gift income-producing property, such as real estate investments or businesses entities that hold real estate, because they feel they may need the income at some point in the future, such as for retirement or a “rainy day.”

Enter the Idea of Transferring Fractional Interest

Thus, the notion of gifting interests in non-income-producing real property, such as a primary or secondary residence, may be especially appealing to such individuals, since these types of gifts do not have as much of an impact on their sense of financial security.  Moreover, transferring only a partial, or “fractional” interest in the residence can provide individuals with an additional degree of economic comfort, because the transferor could continue to own a portion of the property.

With such a plan, property owners could create a trust and gift 50% of the home to the trust and retain the other 50%, allowing them to retain some control while reducing the value of their estate at the same time. That’s the basics, at least, but this strategy is a little more complicated than that, and it can come with more benefits as well.

Another Benefit of This Strategy: The Ability to Take Discounts

When transferring less than 100% ownership in in a residence, the transferor may take applicable valuation discounts with respect to the gifted interest to reduce its value for estate and gift tax purposes. This can happen regardless of whether the gifted asset is a fractional interest in the property or in an entity holding the property.

If the fractional interest being gifted is a minority interest in a closely held business entity, which owns the residence, discounts for lack of both control and marketability should apply. This is because owners of minority business interests generally have little sway over business affairs and are unlikely to be able to force a sale of the underlying real property. They would likely have difficulty selling their minority ownership interests.

In contrast, even though owners of minority interests in real estate generally possess significant rights with respect to the subject property, such as the right to receive a pro rata share of the income, to partition the property or to veto decisions about property use, the U.S. Tax Court and federal appellate courts have nevertheless supported the use of discounting to value fractional interests in real property as well.

Irrevocable Trusts Can Play a Valuable Role, Too

One common way to take advantage of the temporary increase in the federal gift tax exemption is to establish and gift assets to an irrevocable dynasty trust. If you choose to gift non-income producing real property to the trust you would then pay fair value rent to the trust for the use and enjoyment of the residence. However, while gifting assets to a conventional irrevocable gift trust will allow you to transfer assets out of your estate and help protect the gifted assets from future unforeseeable creditors, the downside to using this type of trust is that the gifts are irreversible. This means you will not be able to reclaim the gifted assets at a later time. 

In contrast, by gifting assets to a Nevada Irrevocable Flexible Gift Dynasty Trust — which we call the “HYCET® Trust” (for Have Your Cake and Eat It Too) — you can enjoy all the same benefits available under a conventional irrevocable gift trust. It would allow for flexibility to recapture all or part of the gifted assets down the road in the event you should ever need or want them.  Thus, using the HYCET® Trust as your wealth-transfer vehicle will not only help you achieve your tax-planning and asset-protection goals, but will also afford the peace of mind you desire in light of today’s unpredictable economic and political climate.

An Example to Show How It All Works

Say Bob and Mary own a home worth $5 million.  They create an irrevocable dynasty trust, gift 50% of the home to the trust and retain the other 50%.  They also form a single member limited liability company (SMLLC) and contribute the property to the SMLLC.  Then they transfer a fractional interest (50% LLC interest) that owns the property to the irrevocable dynasty trust. 

The valuation discounts for gifts of fractional interests will be applied to the value of the gift, thereby lowering the amount of the gift to which the couple applies their gift tax exemption (currently $11.58 million per spouse). Discounts could range from 25% to 40% or more, depending on how the operating agreement of the SMLLC is designed.

Half the value of the residence has been removed so that at death, the taxable estate is reduced. While you occupy the residence, be certain to have a written rental agreement with your trustee paying fair market value rent or the IRS will disregard the transaction and include the future value of the transferred interest in your gross estate at your death.

Time is of the essence, though. Once the increased estate and gift tax exemptions sunset, which could be as early as Jan. 1, 2021, the ability to transfer such an extraordinary amount of wealth without estate tax implications will be eliminated, curtailing your tax and asset protection planning flexibility. 

For those who desire ultimate financial peace of mind, gifts of fractional interests in non-income producing real property or in business entities that own such properties to a HYCET® Trust will be an important planning device for achieving these goals.

About the Author

Jeffrey M. Verdon, Esq.

Managing Partner, Jeffrey M. Verdon Law Group, LLP

Jeffrey M. Verdon, Esq. is the managing partner of the Jeffrey M. Verdon Law Group, LLP, a Trusts & Estates boutique law firm located in Newport Beach, Calif. With more than 30 years of experience in designing and implementing comprehensive estate planning and asset protection structures, the law firm serves affluent families and successful business owners in solving their most complex and vexing estate tax, income tax, and asset protection goals and objectives.

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