Property ownership estate planning techniques. (Personal Financial Planning)by Rottenstreich, Zvi
With the top federal estate tax bracket at 55% and the unified credit being phased out for estates of over $10,000,000, the need for planning is clear. Recent changes in the tax law have made estate planning more important yet more difficult. Nevertheless, various property ownership arrangements are still available to reduce estate taxes.
Remainder Interest Transaction R/77
This technique is premised on the fact that any property can be divided into two parts; the current interest and the remainder interest. The current interest is the right to the use of the property or the income from it for a specified period. The remainder interest is the right to the property after the current interest terminates. In the typical RIT a member of an older generation retains the income interest in a property for his or her lifetime and sells the remainder interest to a member of a younger generation. The older owner has the benefit of the income as well as the proceeds from the sale of the remainder interest. The younger purchaser benefits because he pays significantly less for the remainder interest, yet receives the entire property upon the death of the life tenant.
Prior to the enactment of Sec. 2036(c), a sale of a remainder interest allowed for the transfer of the interest with no gift tax and significant estate tax savings. Since the property was sold for full and adequate consideration, there was no gift. At the seller's death, the life interest terminated and accordingly, the only thing includable in his estate was the unexpended proceeds from the sale of the remainder interest, and appreciation in the value of the property from the date of the sale.
While Sec. 2036(c) applies to all transactions, the focus of the prohibitions is to limit planning benefits to non-family members. Disproportionate transfers to and retained interests for family members are not considered to be for full and adequate consideration and result in the inclusion of the property in the seller's estate at its date of death value. For this purpose "family" is defined as a spouse, children, grandchildren, parent or grandparent or any of their spouses. Thus, an RIT is still available for use with non-lineal family members such as a brother, sister, cousin, etc.
There are non-tax benefits to an RIT. It avoids probate and the uncertainty as to ownership of the property upon the seller's death. There are also drawbacks. Upon the sale, there will be an immediate income tax to the seller, if the property has appreciated since acquisition. The property is not includable in the seller's estate, so that the purchaser does not get a step-up in basis upon the seller's death. Funds must be available to make the purchase, and valuation can prove tricky. If the buyer pays too much he might be treated as making a gift to the seller. If the buyer pays too little, then the IRS can argue that the sale was not for a full and adequate consideration and the property could be included in the seller's estate.
A Split or Joint Purchase
A Split is similar to an RIT in that it usually involves members of two generations. However, instead of an older generation sale of the remainder interest to the younger generation, both generations purchase their ownership interests from an independent third party. Each one pays for his or her interest based upon actuarial tables.
A Split yields more income to the purchaser of the present interest, usually the older buyer, who is paying for only a portion of the property but retains the income on the entire property. For example, assume the purchaser of the income interest has $100,000 to invest in bonds yielding 10% and that the actuarially determined purchase price of the income interest is $90,000. If the bonds were purchased without a Split, the investor would earn $10,000. If, however, a Split were employed, he or she would receive the same $10,000 on the $90,000 investment and still have another $10,000 to invest-an additional $1,000 of income.
A Split also provides the purchaser of the life interest with an income tax deduction. The purchase price of the life interest is amortized over the purchaser's life expectancy. This is true even if the underlying property is not depreciable, as long as it is income producing. If the asset is a portfolio type asset (i.e., stocks or bonds) the amortization would be a miscellaneous itemized deduction (subject to the 2% floor). If the asset is a business asset, the amortization would be a deduction against the income generated. If, however, the asset purchased is depreciable in nature, then the purchaser of the life estate is entitled to depreciate the entire cost of the asset, not just his life estate. It is not entirely clear if the amortization deduction would be allowed in addition to the depreciation deduction (or just in lieu of the amortization deduction).
The amortization deduction and the depreciation deduction produce different tax results. The amortization deduction reduces the basis in the life estate only and does not affect the remainderman's original cost basis. The depreciation deduction, however, affects the basis of both the life estate and the remainder interest since the full cost of the property is being depreciated.
Some advantages of a Split are similar to those of an RIT. There is no gift tax and the asset purchased is not part of the estate of the purchaser of the life interest. In fact, since there has been a purchase of the property from a third party, not only does the asset and any appreciation escape estate taxation, but the estate is actually reduced by the funds used to purchase the life estate. Probate is avoided, and there should be no dispute as to ownership of the property. If the life tenant outlives his or her life expectancy he or she has gotten a bargain. If he or she dies before that, the remainderman has gotten a bargain. Similarly, if the property appreciates more rapidly than is anticipated in the IRS valuation tables, the remainderman has made a good investment.
Similar to an RIT, there is no step-up in basis available to the remainderman. Also, valuation can still be a problem, although the purchase from a third party is less likely to raise questions of a purchase for less than full and adequate consideration. Funding of the purchase, and Sec. 2036(c) however, can be critical. The remainderman must use funds not in any way tied to the holder of the life estate. Also, Notice 89-99 gives this further example pertaining to linear family transfers:
"A and A's child B agree to purchase a portfolio of marketable securities of 100X. They intend to hold the securities for investment. A and B purchase the securities through a brokerage account in which A has a life estate; and B has the remainder. A furnishes $75X, the fair market value of the life estate; and B furnishes $25X, the fair market value of the remainder. Through the implementation of the agreement with B, A in effect transfers to B, A's interest in 75% of the potential appreciation in the value of the securities in exchange for B's interest in 25% of the income from the securities. Because the first fraction representing the ratio of potential appreciation to value with respect to A's interest before the transfer (100%/100) is larger than the same ratio after the transfer (O%/100%), A has made a disproportionate transfer. The entire portfolio reverts to A's estate." If a Split is a problem, perhaps a GRIT may be in order.
Grantor Retained income Trust (GRIT)
The Grantor of a GRIT creates a trust funded with property but retains the right to the income for a period. Thereafter, the property (as well as the income) passes to a designated beneficiary. The creation of the GRIT is a gift of a future interest since the designated party does not receive the property until some future date. The current value of the property is multiplied by a fraction (which depends upon the term of the income interest) to compute the value of the gift. This allows the grantor to give away more property at a smaller gift tax cost. The longer the period of the GRIT, and the older the age of the grantor, the smaller the value of the gift.
As long as the grantor survives beyond the term of the trust, the trust property is not included in his or her estate. If the grantor dies during the term of the trust, the full value of the trust property at the date of death is included in the estate. Code Sec. 2036(c) was clearly intended to deal with the type of situation involved in a GRIT; retention of a substantial income interest while transferring potential appreciation. Since it is not yet completely clear how certain significant terms employed in Sec. 2036(c) will be interpreted by the IRS, to be safe, the GRIT should be designed to meet the specific statutory criteria of the section. If a statutory GRIT is not established, the entire value of the property is treated as a gift at the time of the expiration of the trust term and additional gift tax will be incurred.
A statutory GRIT is one for a term of not more than 10 years where the grantor cannot be a trustee. Because of the short term, the amount of property which can be transferred before incurring a gift tax is reduced. It can still, however, provide significant estate tax savings. The future interest is valued at less than whole property, and the future appreciation is also free of estate tax.
A reversion in the trust to the grantor's estate or spouse if the grantor dies before the GRIT term ends, subjects the trust to the restrictive reversion rules of Sec. 2036(c) which returns the trust assets to the estate.
When an individual exchanges an asset in return for an annuity for a specified period of time, and there is a transfer at fair market value, there is no gift tax. The asset transferred is excluded from the seller's estate as is any future appreciation. In linear intra-family transactions it is advisable that great care be taken when establishing a life annuity to avoid possible inclusion in the transferor's estate.
The private annuity arrangement can allow the seller to convert a non- income producing asset into an income stream (the annuity). In most instances, however, the income producing asset is transferred, which can provide the buyer with a partial source of funds to meet his obligation to make the annuity payments. The amount of the annuity should not be a function of the income stream to avoid the inclusion of the asset transferred in the transferor's estate under Sec. 2036.
Since the annuity obligation must be unsecured, the gain on the sale of the property is reported by the seller on the installment basis (i.e., as the annuity payments are received). If the promise is secured, however, the gain must be reported in full in the year of sale and is measured by comparing the seller's basis to the present value of the annuity payments.
If the seller of a private annuity outlives his or her fife expectancy, he or she will collect more than was originally intended and if the proceeds are not expended a higher estate tax will result. If the seller dies before the end of his or her life expectancy, the buyer has achieved a bargain since the annuity obligation terminates.
For example, a father has a rental property which has a fair market value of $100,000 and a basis of $20,000. He is 65 years old and transfers the property to his son in exchange for a private annuity for his lifetime. His life expectancy at age 65 is 20 years. (This is under the mortality assumptions in effect for transfers prior to May 1, 1989. The IRS has until December 31, 1989, to issue tables reflecting new mortality assumptions.) Thus, the amount of each annuity payment would be the amount required to result in a present value for 20 years of payments equal to $100,000. The rates to be used in calculating the annuity are to be 120% of the federal mid-term rate compounded annually in effect for the month in which the transfer takes place. Assuming a 10% rate of return, this payment would be $14,712 per year. For each of the first 20 years, as the annuity payment is received, the father would have taxable income of $13,712 ($14,712 less basis of 20,000 divided by 20). In each year after 20, the annuity would be fully taxable.
The son's initial basis for depreciation purposes is the 100,000 fair market value at transfer. If the father fives 10 years, the son pays a total of $147,120. Since the present value of this was less than $100,000, the son has a bargain. If the father lives for 25 years, the son pays $367,800 and the father has a better deal than expected. Sec. 2036(c) should not affect this transaction since the transferor is not maintaining an interest in the property.
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