I remember my naïve days when I thought that the only thing a student of the markets needed to figure out was the assets that performed best. If something grows at 15%, it is going to beat something that grows at 11%. Something I completely underestimated in my early analysis of estate management is the role that the tax code plays in shaping returns. This is especially true when trying to figure out the most effective ways to pass on assets to kids and grandkids. This is an area where the *structure* of the holding can have a greater determinative effect on how much wealth is transferred than the actual growth of the underlying holding itself.
The importance about holding structure has been reinforced in my mind as I have studied qualified personal residence trusts, a rare type of irrevocable trust that allows the original owner of a primary home or vacation property to reap the benefits of property use before passing on ownership of the property to the kids or grandkids.
Broadly speaking, a qualified personal residence trust allows you to take advantage of the taxable gift portions of the tax code that relate to property in an effort to discount the fair market value of your property that you intend to transfer to your beneficiaries.
A qualified personal residence trust means that you plan to live in your property for a set period of time (a term of years) and thereafter you transfer the property to the named beneficiary. There is one catch: If you die before the term of years, the tax savings benefits are compromised. If you outlive the term of years stated in the irrevocable trust instrument that creates the qualified personal residence trust, then you must either vacate the property or pay fair market rent each month to the beneficiary to remove the possibility that the IRS will challenge your qualified personal residence trust as a defective/fraudulent transfer.
This creates a conundrum: The greatest tax savings occur if you spread out the term of years in which you remain in the property before the beneficiary assumes ownership. But if you create a qualified personal residence trust that has a twenty-year term of years, and you die nineteen years later, then you have defeated the tax savings benefits offered by the tax code. If you only create a qualified personal residence trust that has a five-year term of years, then the tax savings will be minimal and you will have to either leave or pay rent to stay in your former home.
Imagine if you are sixty year old father and you intend to use a qualified personal residence trust to pass on a property to your two kids. How should you set the term of years given that you don’t know when you will die at the time you create the irrevocable trust? In my view, the best plan is to create an irrevocable trust instrument that transfers fractional interests in property over a graduated period of time.
In other words, the instrument might give each kid a 1/10 interest (1/5 total) at the five-year mark, another 1/10 interest to each at the ten year mark (2/5 total), another 1/10 interest to each at the fifteen year mark (3/5 total), another 1/10 interest to each at the twenty-year mark (4/5 total), and another 1/10 interest to each at the twenty-five mark (5/5 total).
If you die eighteen years after creating the instrument, you have already captured the tax savings on 60% of your property and your estate only has a 40% interest in the property that is capable of being subject to the estate tax. The IRS demands that the transfers be “logical and not arbitrary or capricious” so you can’t transfer 99% of your property after one year and then hold the remaining 1% for sixty years to effectively maintain use of the residence until death.
I have never heard of someone creating a qualified personal residence trust without the aid of legal counsel. But it is worth the complication if you have a high-value home in an area that experiences rapid appreciation in property values like New York or Southern California. When executed over a three-decade time frame in a hot real estate area, it is possible that a qualified personal residence trust can save your heirs or beneficiary hundreds of thousands of dollars. This is one of those rare instances where the structure of your estate can have a greater effect on the amount of passed-on wealth than the actual appreciation of the property itself.