Strategy to Counter Estate Tax Less Appealing

Arden Dale for the Wall St Journal writes: But advisers say the trusts no longer make sense for many people now that the federal government only taxes estates of $5.25 million and over ($10 million for couples). The trusts were introduced in 1990 when the exclusion level was much lower.

Meanwhile, advisers are looking at whether it makes more sense to keep a client's trust in place--or unwind it so that the home goes back into the estate. All of that depends on the current size of the client's estate as well as the value of the home. If placed into the estate, heirs stand to save more in capital-gains taxes than they would in estate taxes.

Heirs pay the capital-gains tax on inherited property based on the fair-market value of the home at the owner's death, not the amount the person originally paid for it. This is known as a step-up in basis, and refers to the cost basis of the property.

"These are transactions that looked perfectly good at the time they were done, but the higher estate tax exclusions make them look not so good now," said Don Weigandt, a wealth adviser in the Los Angeles office of J.P. Morgan Private Bank.

For example, J.P. English, a senior financial planner in the Family Wealth Group of Key Private Bank in Mayfield Heights, Ohio, is working with a family whose matriarch set up a trust in 2003 to transfer a home to family members. At the time, the trust made sense because the federal government taxed estates starting at $1 million.

The woman's family would now prefer to have the property included in her $2 million estate. Adding the home worth $1 million to her estate would not swell it to the $5.25 million threshold. And, of course, it would reduce capital-gains taxes substantially when heirs eventually sell the property.

"As financial planners, our job is to take a holistic, comprehensive view," Mr. English said. "In this case, they had a done a very good job of planning for the estate tax at the time, but you have to look at the income tax effects as well."

Unwinding the trusts--that is, getting a home back into an estate--must be done carefully to avoid breaking the rules and raising red flags with the Internal Revenue Service. Advisers and their clients need to work with tax attorneys to pull it off.

The trusts transfer ownership of the property over time, but let the original owner stay in the home. Usually, they are set up so that when the transfer is complete, another trust owns the property. Often, the original owner continues to stay in the home, renting it from a grantor trust. That way, rental income isn't taxable.

Kenneth Brier, a partner in the Needham, Mass., law firm of Brier & Geurden, is working with a client who set up two of the trusts years ago--one holds a personal residence in the Boston area, the other a vacation home on Cape Cod. The options to get properties back into the estate are limited, because the terms of the trusts are so inflexible, Mr. Brier said.

The IRS might look suspiciously, for example, if the original owner lived rent free in the home after the QPRT transferred ownership to someone else.

"It can be tricky, because there are gray areas when it comes to intentionally clawing back an asset that already has been passed to someone else," he said.