In many parts of the country, the home in which you raised your kids, who have left the nest, has likely experienced significant growth in value. Now the house is too big for the two of you and you want to downsize. You are not alone.
This is one of the most vexing questions many of our clients face as they move toward their senior years. Moreover, the equity in the home is a significant asset and if you live in a high tax state like CA, HI, NJ or NY, the meager homestead exemptions don’t provide much of a shield from an unforeseen lawsuit. If you sell the property, what do you do with the profit?
If you have lived and used your home as your primary residence for two of the past five years, there is a $250,000 exclusion from capital gains ($500,000 if married and filing jointly). Your federal capital gains tax rate above the exclusion is 23.8% plus your state tax (CA is 13.3%). If you hold onto the property until you die, half of your basis will receive a step-up (100% if you live in a community property state) and upon sale will exclude all of the gains up to the date of death value.
But if you love your home and want to remain in it, how do you protect the residence from lawsuits? Many folks own their residence in joint tenancy or in a revocable living trust. These methods of holding title subjects your equity to lawsuit judgments if sued. So, if you want to downsize or remain in your property, here are a few planning options that could allow you to have your cake and eat it too.
Qualified Personal Residence Trust (QPRT)
The QPRT, which may be used only for the personal residence or a vacation home, is a “split interest”. You retain the right to live in the property for a predetermined term of years after which the property (called a remainder interest) belongs to your kids. If you want to remain in the property you rent from them at fair rental value. The shorter your term, the larger the value of the gift of the remainder interest to the kids and vice versa. You can use all or part of your current $11.4M per person gift exemption to offset any gift tax liability on the gift of the value of the remainder interest to the kids. If you die during the term of years you selected, the value of the property is part of your gross estate and subject to estate tax. If you survive the term of years you select, then the property is removed from your gross estate and you avoid any estate tax on the appreciation of the property owned by the kids. If you want to remain in the property after your term of years expires, you may rent from the kids at fair rental value.
Asset protection is achieved because the ownership changed title from you or your revocable trust to the QPRT. From an enforcement or judgment standpoint, your future creditor has only the right to attach the remainder of your term of years but not the underlying property. On balance, your future creditor isn’t interested in the remaining term of years as it is virtually useless to a judgment creditor. Several courts have upheld the protections associated with the QPRT.
Dynasty Trust
If you want to preserve the property for your children and not subject it to their lawsuits, divorcing spouses, IRS liens or bankruptcy, transfer the property to a dynasty trust instead of to the kids outright. You may do this by way of a gift or sale to an irrevocable dynasty trust (generation skipping trust), in which you are not named as a beneficiary. Using your $11.4M per person gift tax exclusion you may make the gift and avoid any gift tax liability. If you have little or no gift exclusion remaining, you may sell the residence or vacation home to the dynasty trust and then lease the property for fair market rental value from the trust. Becoming a tenant vs. owner protects the property from your future unforeseen creditors (and those of your children and grandchildren).
With this plan, you can have your cake and eat it too – you removed the appreciation from your gross estate (especially if the gift and estate tax exemption laws are reduced) and you have “quarantined” the property from a future lawsuit. One downside is this planning will eliminate the step-up in tax basis at death. We have devised a workaround to this conundrum once the first spouse dies that will allow you to restore the property and receive the step at death.
So, if you are perplexed as to what to do with your home or vacation house after the kids have left the coup, speak to your tax advisor about a QPRT or a gift/sale leaseback to a dynasty trust.
If we can be of further assistance, contact the firm for a complimentary consultation.
Jeffrey M. Verdon, Esq.
For more information about any of the information discussed in this Client
Alert, or any other income or estate tax planning or asset protection planning assistance, please contact the: Jeffrey M. Verdon Law Group, LLP at jeff@jmvlaw.com or 949-333-8143.