Austin Kilham for the Wall St Journal writes: The husband and wife, both 60, had bought a $2 million vacation home in Colorado after the market bottomed in 2008. The home was a foreclosure, and the couple was able to buy the property for less than market value.
But in early 2012 the couple saw signs of recovery in the Colorado real-estate market and turned to their adviser, John K. Howk, for help. They were concerned about a potential increase in the estate-tax rate, as well as the rebounding value of their home. They wanted to gift the house to their children as soon as possible to minimize gift taxes--but they also wanted to retain the right to use the home for several more years.
"This client was focused on avoiding estate tax to the nth degree," says Mr. Howk, senior vice president of the Client Advisor Group at the Private Bank atBOK Financial BOKF +0.29% in Tulsa, Okla., which manages $50.4 billion for 3,000 clients.
Complicating matters, the couple planned on making use of their lifetime gift-tax exemption for future gifts. So Mr. Howk suggested that the clients use a qualified personal residence trust (QPRT) to gift the home. Under this plan, the couple would owe gift taxes on the depressed value of the home, but the trust allowed any future appreciation of the home to be passed tax free to the children.
Because the couple wanted to continue using the home, Mr. Howk suggested they set the term of the trust for 10 years. The couple could use the home during the term, and then transfer it to their children when it ended.
However, Internal Revenue Service rules required the couple to subtract the value of the home's use from its current value. Using an IRS formula, the couple and their adviser calculated the use value to be $300,000 for a decade of use, which they subtracted from the $2 million value of the home. The result: The couple paid about $510,000 in gift taxes on the remaining $1.7 million value of the home.
At the end of the 10-year term, the house will be transferred at its appreciated value to the children with no additional taxes. Based on housing market trends in the area, the couple estimated that the house would appreciate at 7% per year--meaning its value could increase to $3.9 million at the end of the term. Were that to happen, locking in the value of the house at $1.7 million would save the couple more than $780,000 in gift taxes, says Mr. Howk.
Although the solution worked well for his clients, Mr. Howk notes a QPRT isn't a perfect fit for everyone. Clients should live in an area where real-estate prices are likely to see a lot of appreciation. Age is also a factor, because if the client dies before the end of a trust's term, the property passes immediately to the beneficiaries, which can reduce the amount of time to build value.
However, Mr. Howk's clients are young enough that surviving the 10-year term is less of concern for them, he says. "This was the perfect solution," says Mr. Howk. "Not only could the clients give a generous gift, but they were able to do so at the distressed price so all future appreciation will go to the children."
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