The economy is currently in a recession with the real estate market seeing some of the biggest declines. Due to this decline people’s family homes probably have not appreciated much in value. One important benefit of leaving the family home to children in a will is that the children would get a step-up in basis. This means that the children would not have to pay tax on the appreciation in the property that occurred before it was transferred to them. Thus, the current economic and real estate climate takes away the big advantage of leaving the property to children in a will.
The current tax climate also makes it advantageous to transfer the family home to one’s children now. Currently, the lifetime gift tax exemption is $5.12 million and the gift tax rate is 35%. The lifetime gift tax exemption amount has generally been set at $1 million and the gift tax rate has generally been higher. So with this high exemption amount a parent could transfer the family home to his or her children with no gift tax due, assuming he or she has not made lifetime gifts before this that would use up the $5 million exemption. I will outline three options for transferring the family home now below.
The first option is transferring the property to one’s children as tenants-in-common. This means they will each own an undivided interest in the property. Some of the benefits of this approach are that the value of the property and any future appreciation will be out of the donor’s estate. Also, since the children will have undivided interests, certain discounts will apply in calculating the gift, such as minority interests, so the amount of the gift will actually be less than the total value of the property.
This option also comes with some costs. The costs to effectuate this transfer include having to file new deeds showing the children as the owners. The gift tax costs will be zero if the donor still has enough exemption left to cover the gift, but if not then the donor will be able to use discounts to lower the value of the gift. There will be no costs to the donor to administer the property or for on-going use once it is transferred, because the donor will no longer own it. If the donor wants to continue to use the property, the donor will have to pay his or her children a fair rental value. But if the donor does not pay rent, the children will be treated as giving the donor a gift.
Qualified Personal Residence Trust (QPRT)
The next option is transferring the property into a qualified personal residence trust (QPRT). A QPRT allows the parent to make a gift of the property to a trust for the benefit of the children. Also, the parent can reserve the right to use the property for a specified number of years rent-free and upon expiration of the trust term, the property would be distributed to the children.
One benefit of the QPRT approach is that the donor is able to still use the property rent-free for the trust term. Another benefit is that as long as the donor outlives the trust term, the property and any appreciation during the trust term will not be in his or her estate. Also, gift tax is only paid on the value of the remainder interest that will pass to the children, instead of the whole property value. So the longer the trust term the lower the value of the remainder and the gift.
The QPRT approach does not come without costs though. The costs to effectuate this transfer include drafting the trust agreement and possible payment to a trustee. The gift tax costs will once against be zero if the donor still has enough exemption left to cover the gift, but if not gift tax will only be paid on the value of the remainder. Since the donor will still have the right to use the property for the term of the trust, he or she will have to pay the costs to administer the property and to use it during the trust term. Also, if the donor wants to continue to use the property after the trust term, he or she will need to pay a fair rental value to the children.
The third option is to transfer the property into a LLC and then gift units in the LLC to the children. The transaction must be structured in that order to get the benefit of it. One benefit of this option is that discounts, such as minority discounts and lack of marketability discounts, are applied to the gifts making the gift value less than the full value of the property. Another benefit is that a LLC can protect the underlying assets, and the members of the LLC from liability. Also, restrictions can be placed in the LLC agreement, such as transferability restrictions.
This option comes with costs and many more obligations than the other two options. The costs to effectuate this transfer include setting up the LLC, transferring the property to the LLC and changing the deed, getting an appraisal of the property, and getting an appraisal of the fractional interests to calculate the gifts. The gift tax costs will once against be zero if the donor still has enough exemption left to cover the gift, but if not then the gifts will be reduced by the discounts. Since the LLC now owns the property, it will be responsible for any costs to administer the property and any costs for its ongoing use. If the donor wants to continue to use the property, he or she will need to pay fair rental value to the LLC.
This option has many other obligations that must be adhered to. The LLC must be managed and run like a business. This means that the LLC must have meetings, take minutes, pay the costs associated with the property, and in general just follow LLC formalities. The donor will also want to make sure he or she does not retain management control over the LLC, because then the property could be pulled back into the donor’s estate. Another issue with this option is that LLC agreements can be amended much easier than a trust so it does not provide as much certainty.
What’s the best option?
The three different options all come with benefits and costs that must be weighed. The LLC option has much higher costs than the other two and requires much more on the part of the donor and the children to make sure all the requirements are met to receive all of the benefits. The tenants-in-common option is not as desirable because the donor is basically giving up all control. Also, there are no documents with the tenants-in-common option, such as a trust agreement or LLC agreement, that allow the donor to make restrictions or specify what he or she wants to happen. The QPRT allows the donor to keep using the property rent-free while also getting the property out of the donor’s estate, as long as the donor outlives the trust term. An issue with using a QPRT is that it is best to use them when the interest rates are high and right now the interest rates are very low. These are just three of many options to utilize in transferring the family home, and as displayed above, many factors need to be weighed before choosing a particular option.