For many of our clients, their greatest assets are in real estate. This may mean that their children will be forced to sell property to pay estate taxes within nine months after they lose their second parent. There are many techniques available to help ensure against the necessity of a “fire sale.”
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Irrevocable Life Insurance Trusts funded with Second to Die Insurance
The easiest way to prevent a forced sale of real property is to provide funds with which the children may pay estate taxes. Second to die life insurance policies serve this purpose. These policies have lower premiums because they insure the lives of both husband and wife. They do not pay out until the second death, which is when the funds are needed to pay the taxes.
Many have heard that insurance is tax free, but did you know that it is subject to the estate tax? This means that the kids will only receive about half of the insurance that mom and dad thought they were purchasing. This can be easily avoided by placing all life insurance into an Irrevocable Life Insurance Trust (ILIT). A properly drafted ILIT can ensure that all proceeds will pass to the children free of tax.
So what does all this mean? A properly funded ILIT can provide the children with tax-free funds with which to pay the estate taxes and not be forced to sell the home.
Qualified Personal Residence Trusts
While ILITs and second to die policies provide the children with funds to pay taxes, a Qualified Personal Residence Trust (QPRT) will act to actually lower the final estate taxes due. These Trusts are used for mom and dad to make a lifetime gift of the home to their children. The home will be placed into the QPRT for a certain term of years (anywhere from one to 20 years). At the end of the term of years, the home will revert to the children (usually in the form of a Children’s Trust so the kids do not actually receive the property until they get the rest of their inheritance).
By delaying the gift for a certain term of years, the value of the gift (and therefore the amount of the $1,000,000 exemption that is used) is greatly discounted. For example, if mom and dad were to simply gift a $2,000,000 home to their children today, their entire combined exemption would be used. However, if they gifted the home through a QPRT with a 20 year term (based upon an age of 60 years), only $400,000 of their combined exemptions would be used. In addition, by placing the home in the QPRT now, all future appreciation is attributable to the children. So even if the home has tripled in value when the children are settling mom and dad’s estate, there will be no taxes due!
Limited Liability Companies
If mom and dad are purchasing a home for a child or with a child, it may be a good idea to place the home into an LLC. In addition to the creditor protection these are designed to offer, a properly structured transaction could allow the home to be passed to the child estate tax free. Under these structures, a Children’s Trust will own the property; therefore, it will not be includable in the parent’s estate. However, they are structured so that the parents will retain complete control.