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Personal Residence Trusts Offer Estate Tax Savings

By Albert B. Crenshaw
(c) The Washington Post
Sunday, June 18, 1995; Page H01

Back in the 1970s, when the estate tax was last overhauled, $600,000 seemed like a lot of money.

Estates up to that amount, Congress decided, should not be taxed, but above that amount rates would be very steep.

Today, millions of American families have assets of more than $600,000 and the number is climbing steadily. Congressional Republicans say they want to raise the threshold to $750,000; while helpful, that still would leave many families who think of themselves as middle class facing hefty tax bills.

There are a number of ways to minimize these taxes, of course, and while many of them are better suited to the truly rich, there are some that can be quite useful to the not-quite-rich as well.

One of these is the "qualified personal residence trust," or "personal residence GRIT" (grantor retained income trust). Added to the tax code in the late 1980s, this is a device that allows you to give your house away, thus getting it out of your estate, while continuing to live in it for many years and ensuring that your heirs eventually will get it.

These trusts are especially useful for the homeowner who expects to leave the area at retirement, or who has a valuable vacation home that he or she would like to pass on to the children with a minimum of tax. A trust of this kind both "freezes" the value of the property for estate tax purposes, and preserves more of the estate tax credit (which shelters up to $600,000 from tax) for other assets.

"It's a very popular technique," said David Gerson, a tax partner in the New York offices of Ernst & Young, the accounting firm.

It works this way:

You set up a trust with your heirs as beneficiaries. You then make a gift of the house to the trust but retain the right to live in the house for a specific period of years. If you are 50, for example, and expect to retire to Florida at 65, you might make the term 15 years. You can make the term any number of years, but you have to use a specific number.

At the end of the term, title to the property passes to the trust beneficiaries (presumably your children), and you must either move or rent the house from them at a fair market rent.

When you transfer the house to the trust you do incur gift tax, but that can be folded in with your estate tax and can be applied against the $600,000 exclusion.

When you transfer your house to a personal residence trust, the tax is assessed only on what is called the "remainder interest," which is the value of the property after deducting for your right to live there. The value of remainder interest depends on the number of years you can live in the house, and current interest rates -- the Internal Revenue Service has tables for this -- but the longer the term and the higher the interest rate the lower the remainder interest.

The property will revert to your estate if you do not outlive the trust term, however, so you should choose a term you are likely to survive. Experts also advise including in the trust a provision that the property reverts to your estate if you die.

In addition, since the value of the property is frozen for estate tax purposes at that point, any appreciation in the house after it is placed in trust is excluded from your estate.

Take an example: Suppose you have a $300,000 house, and you expect to live in it 10 years. The remainder interest will be valued at about $100,000 at current interest rates. So you use $100,000 of your $600,000 exclusion to cover the gift tax.

Now suppose that over the 10 years the house appreciates by $100,000. Had you done nothing, you would have had a $400,000 asset in your estate, leaving only $200,000 of your credit for other assets. With the trust, $100,000 of your exclusion has taken care of the house, and there's $500,000 left to cover other assets.

The greater the value of the house the greater the savings.

"Let's say you have a home worth $1 million now and let's say the remainder interest gift gets discounted to $350,000. If the home stays at $1 million you would have removed $650,000 from {your estate} and if the house doubled {in value} you would have removed all that additional appreciation" from the estate, Gerson said.

The trusts are easiest to do if the mortgage is paid off, but can be done if there is a mortgage.

There are some other points to note:

The house has to qualify as you personal residence for the entire term of the trust. This is mainly meant to exclude rental property. So a vacation house can qualify, as long as you occupy it for at least the greater of 14 days or 10 percent of the number of days it was rented. In fact, you can put both your main home and a vacation home into a personal residence trust, as long as they meet the personal residence test.

If you think you might want to live in the house beyond the term of the trust, you must generally pay fair market rent to your heirs who now own the house. Buyback provisions can be built into the trust if you wish.

Your heirs will not get the "stepped-up basis" that goes to assets transferred via estates. Thus, if they sell the property, they will have to pay tax on the amount by which it has appreciated since you bought it. This is not always as much of a disadvantage as it seems, however. Capital gains rates are capped at 28 percent and apply only to the appreciation, while estate tax rates range up to 55 percent and are on the full value of the asset. Also, if the heirs don't plan to sell -- as they might not if it's, say, a vacation home that you've had for generations -- it's not an issue.

The income tax aspects of homeownership don't change during the trust term.

While personal residence trusts are relatively easy to understand, financial planner Ric Edelman of Edelman Financial Services in Fairfax cautioned that they require an expert to set up. Also, he said, many people are uneasy with the idea that they will have to give up their house in a set number of years.

"It is relatively new," Edelman said. "It has not yet caught a lot of attention with practitioners, and consumers still know nothing about it. Over time we think it will become more routinely used."