Shielding Your Assets From Estate Taxes

Reduced home values and low interest rates work in your favor when it comes to two strategies that could save your heirs a bundle on estate taxes.

As part of the American Taxpayer Relief Act passed in January, Congress has permanently set the federal estate tax exclusion amount at $5 million, indexed each year for inflation. In 2013, the amount each individual can exclude from estate taxes is $5.25 million. In addition, "portability" became a permanent part of the estate tax, so when one spouse dies, the other can take the unused portion of the exemption and apply it to his or her own estate.

The high exclusion amount means only the very rich will need to worry about saving estate taxes. But among those with wealth primarily concentrated in their home or investment portfolio, there are two types of trusts designed to transfer wealth to heirs and save taxes by removing the assets from the estate. In effect, this reduces the amount of the decedent's taxable wealth.

One is a grantor retained annuity trust, or GRAT, typically used to shelter future appreciation of stocks. The other is a qualified personal residence trust, or QPRT, that will shelter current and future appreciation on the value of your home. Both are set up for a predetermined term of years, and in both cases, the creator of the trust must outlive the term, or the assets go back into the estate.

An important factor for both of these techniques is the interest that will be charged on the value of the assets transferred to the trust. The 7520 rate, also known as the hurdle rate, is set by the Internal Revenue Service every month and is based on recent sales of three- to nine-year Treasury notes. When it's low, as it is now, it's beneficial to set up a GRAT. If the trust can beat the hurdle rate, the remainder of the appreciation passes to heirs tax-free. Once the trust is set up, the hurdle rate won't change for the life of the trust. The rate has been hovering just above 1%: The June rate is 1.2%. Compare that with a double-digit rate in the late 1980s.

According to Thornton "Tim" Henry, tax attorney at Jones, Foster, Johnston & Stubbs, P.A. in West Palm Beach, Fla., the low hurdle rate won't help the QPRT. But, reduced home values make it an attractive technique to consider right now.

Following is a closer look at the two types of trusts.

Putting your home in a QPRT

This type of trust allows a person to still live in a home for the term of the trust, deduct mortgage interest and real estate taxes, and then when the term of the trust expires, the home passes to the heirs and out of the owner's estate. The owners can retain the right to live in the home for the rest of their lives by paying fair market rent to the heirs.

Henry says there are three factors to take into consideration when setting up a QPRT:

Life expectancy. The owner has to outlive the term of the trust, or it comes back into the estate as if the trust never existed. "In that case, you haven't lost anything, but you haven't won," says Henry. So it's a best-guess scenario. Typically for a healthy 70-year-old, 10 years would be a reasonable term.

The tax hurdle rate. The QPRT is one of the few trusts that does not benefit from a low hurdle rate. That's because the value of the gift is determined by the fair market value of the home, minus the "retained interest," or the owner's right to live in it for a term of years. The value of the retained interest is determined by the age of the grantor when the trust is set up, the term of years for use of the home and the hurdle rate. Ideally, a higher hurdle rate will mean the retained interest is higher, so the value of the gift is lower (fair market value of the home minus the retained interest equals the value of the gift). With a QPRT, the grantor is removing the home from his estate, thereby saving estate taxes and also saving gift taxes because the value of the gift is less if the hurdle rate is high.

The value of the home, based on appraisals. In the current housing market with low home prices, "clients are interested" despite the low hurdle rate, Henry says. For example, he adds, if a 70-year-old puts a home in a QPRT with a 10-year term, the value of the gift will be derived from the IRS calculations using the donor's age, the term of years and the current hurdle rate. If the home were to appreciate 4% per year, at the end of 10 years all appreciation above the value of the gift will pass tax-free to the heirs.

Obviously there's some guessing involved about where home prices are headed and when. For example, if someone had put home valued at $1 million home into a QPRT when home prices were soaring and the value of the home dropped to $450,000, it's not such a great deal, says Henry. "But if you think home values have bottomed out, now is the time to do it."

Capturing appreciation from stocks

A popular type of GRAT right now for stocks you think might appreciate, according to Henry, is called the short-term, zeroed-out GRAT. The term is only two years, and at the end of the first year, the trust pays back the grantor, or the creator of the trust, approximately 46% of the value of the assets that were put in the trust. At the end of the second year, it pays 54%. So, in effect, the grantor gets the assets back that he put in (in cash or original stock), and all appreciation above the hurdle rate goes to heirs tax-free. That's why it makes sense to put in a stock the owner thinks will rise rapidly, for instance, one on the verge of going public.

If the stock doesn't appreciate, "the worst-case scenario is that the owner gets the asset back and there was no gift," says Henry.

The current low-rate environment and depressed home prices are making GRATs and QPRTs particularly attractive estate tax techniques now, but Henry says clients always need to keep the larger question in mind when deciding to give away assets: "How much can you afford to give away -- or, said another way -- how much do you need to keep to feel comfortable?"