By: Estate Planning Attorney Kenneth A. Ziskin
If you want to protect your loved ones from estate and gift taxes that currently run at 40% after you have used your lifetime exclusion, a Home Security Trust (“HST”) strategy can provide a great solution. It will usually work better than an older strategy, the Qualified Personal Residence Trust (“QPRT”).
Most investors can implement an HST strategy without property tax reassessment, get all or most of the value of the home out of their estates, and still arrange for a step-up in basis to save capital gains taxes for their heirs. If the house is sold during the grantor’s life, the grantor will normally also be able to exclude $250,000 of gain under Internal Revenue Code § 121.
An HST provides one of the simplest, yet flexible, tax and cash flow efficient ways to continue to occupy your home, while immunizing growth in value of the home (and, over time, the rest of the equity) from estate tax exposure.
What is a Home Security Trust Strategy?
A Home Security Trust strategy for a married couple involves setting up two irrevocable trusts (one for each spouse), making a small gift to “seed” each HST, and then having each spouse sell his or her respective interest in a home to the HST.
1 For unmarried grantors, the HST can also work well, but only one trust is needed. However, while a unmarried grantor can also avoid property tax reassessment on his or her principal residence, the use of another residence may require use of the grantor’s $1 million exemption for a parent-child transfer in order to avoid reassessment
It can work with both your principal residence and a vacation home.
We craft each HST so that it will be treated as a “grantor trust” for income tax purposes under Internal Revenue Code §§ 671-678. That means that, for the life of the grantor (the person who makes the only gifts to the HST), the grantor will be treated as though he or she owned the property of the HST for income tax purposes. Generally, the grantor retains a power to substitute, or exchange, other property for the home that was transferred to the HST. This power qualifies the HST for Grantor Trust purposes.
However, we also craft the HST so that it will not be treated as owned by the grantor for gift and estate tax purposes. This gets the property of the HST out of the grantor’s estate, and effectively “freezes” the value for gift and estate tax purposes.
Where spouses each do their own HST, care needs to be taken so that the HSTs will not be treated as “reciprocal trusts” under IRS guidlines.
How the HST Works
After the HST has been drafted, the grantor makes a small gift to the HST (at least equal to 10% of the value of the grantor’s share of the home, or 5% of the total value when two spouses own the home in equal shares). The gift can be money, other property or a partial interest in the couple’s home (usually 5-7% for each spouse). While it often makes sense for the gift to include some liquid assets, the HST gifts need not include any cash or liquid assets.
Immediately after the gift, the grantor then sells his/her remaining interest in the home to the respective HST. The HST pays for it with an installment note equal to the full fair market value of the interest sold, based on a qualified appraisal.
Finally, the grantor signs a lease to rent back the HST’s interest in the home for a fair market rent. Payment of a fair market rental keeps the grantor from have a retained interest that would bring the home back into the grantor’s estate for estate tax purposes.
Tax Advantage of Grantor Trusts
Grantor Trust treatment has three major advantages.
First, any transactions between the grantor and the HST are ignored for income tax purposes. So, the rent and interest payments between the grantor and the HST, and any “gain” on the sale are ignored.
Second, if there is any income earned by the HST, it benefits the descendants of the grantors, but any income tax attributable thereto is paid by the grantors. This helps “squeeze” down their taxable estates.
Third, the grantor can buy property from the trust without recognizing any capital gain. This allows the grantor the option to get the property back into his or her estate so that the grantor’s heirs will get a step-up in basis at the grantor’s death. If the grantor buys the home back with a note, or other high basis assets in the grantor’s estate, the net result does not increase the grantor’s taxable estate.
Advantages of an HST over a QPRT
QPRTs have enough advantages for taxpayers that the Clinton Administration asked Congress to outlaw them around the turn of the century. However, the HST Strategy works “like a QPRT on steroids,” without the troublesome disadvantages Congress and the IRS built into the QPRT rules.
The advantages of the HST strategy over a QPRT include:
- The HST generally uses less of a client’s lifetime estate and gift tax exclusion amount.
- The HST avoids the QPRT risk that the home will come back into the client’s estate at full value if the grantor does not survive the term of years selected at inception of the trust. This creates a real dilemma when creating a QPRT: a longer term uses less of the grantor’s gift and estate tax exclusions, but increases the risk that the QPRT fails to work at all if the grantor dies before the end of the term.
- The HST usually uses less of your Generation Skipping Tax (GST) exemptions, which makes it more valuable for property that may ultimately benefit grand-children and younger generations.
- The HST can provide a means to obtain a step-up in basis at the grantor’s death, which the QPRT rules prohibit unless the grantor dies before the end of the QPRT term. That step-up can be obtained using the HST without increasing the grantor’s estate tax exposure. On the other hand, under the QPRT rules, your heirs get either an estate tax benefit, or a step-up in basis, but not both. The HST can give your heirs both.
- The HST escapes most of the technical restrictions imposed by the QPRT regulations.
- The HST allows for greater flexibility in structuring cash flow issues than does a QPRT. Generally, note payments will be close to the amount of rent paid by the grantor to the HST. After the notes are repaid, the married grantors (and surviving spouses) may be able to remain in the home rent-free with proper structuring, or can get distributions that offset some or all of the rent. Of course, for wealthier grantors, the best strategy is to continue to pay rent that provides a further wealth transfer free from painful gift and estate tax consequences.
2 Some commentators believe that gain on sale may be recognized to the extent the note is outstanding at the grantors death. Normally,
clients arrange to pay-off the note prior to that date.
HST Example for the Millers
The Miller’s, ages 70 and 68, have a net worth of approximately $9 million, including a home worth about 1.5 million. While their current combined estate tax exclusions protect their heirs from estate taxes, they believe that, over their remaining life expectancy, the assets will grow enough to expose their heirs to nearly $1,500,000 in estate taxes.
Each of them sets up an HST, and gives a 6% undivided fractional interest in the home to the respective HST. Generally, the ownership rights accompanying a fractional interest in real estate do not have a value equal to a proportionate amount of the value of the entire real estate. Appraisers we have used suggest that the discount should be at least 20%, (and probably more like 30%). So, a 6% interest in the home would have a value of $72,000 ($750,000 x 6% x 70%). Thus, each of the Millers would use just $72,000 of their lifetime exemption in connection with the gift to their HST.
Then, each of the Millers sells a 44% interest in the home to the respective HST, in exchange for a promissory note equal to the value of the interest sold. Each note would have a principal amount of $528,000. The notes usually bear interest at the long-term Applicable Federal Rate (2.55% per annum in October, 2015), although in some cases lower mid-term and short-term rates make sense.
[The promissory notes remain in their respective estates, but can be reduced each year as the HST’s make principal payments.]
The Millers then agree to rent the home from the HSTs for a total of $7,500 per month (on a triple net basis), with rent to increase 2% per year. Thus, the HSTs each get $45,000 the first year in rent, and each HST pays its grantor not less than interest on the note (about $7,500 per year). Since the Miller’s wanted most of the positive cash flow of the HST’s used to amortize the notes, the note payments are set at $15,000 less than the rents. We help each client determine the differential between rent and note payments based on their particular needs and situation.
By year 15, the notes are paid in full, and the HST holds property (assuming 3% annual appreciation) and cash totaling about $3 million, all of which will transfer free of estate taxes.
Result of the HST Strategy for the Millers
At their joint life expectancy, this should keep them free of estate taxes, and transfer about than $3 million in value to their heirs, free of gift, estate and generation skipping taxes that would otherwise have been imposed.
The estate and generation skipping tax savings from the HST Strategy (assuming this value goes to grandchildren) would total approximately $2 million (the combined effect of estate and generation skipping taxes is about 64%!!).
As with all strategies, you need competent legal advice on your particular situation before determining whether it will be suitable for you. This article discusses only some of the features, advantages and issues related to the HST. It cannot substitute for individualized legal advice.
3 We determine the actual rent based on an appraisal of fair rental value. Your discounts may vary from those used in this example.
This article is intended to assist readers to get a general understanding of some estate planning concepts relevant for income property owners. To keep it concise, it does not discuss all of the exceptions, qualifications and other concepts that might affect their utility in your situation. You can only rely on counsel you specifically retain, and not on these materials, in connection with your planning.
Kenneth Ziskin is a Los Angeles (Sherman Oaks) estate planning attorney who concentrates his practice on integrated estate planning for income property owners throughout California, from San Diego to the Bay Area. Ken lectures regaulary to apartment owner associations. He focuses on integrated planning to save income, property, gift and estate taxes. He holds the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, and a perfect 10 out of 10 rating on legal website AVVO, which also presented him its Client Choice Award in 2014.
Kenneth Ziskin will present his seminar on “Estate Planning for Apartment Owners” in San Diego on Thursday, December 3, 2015 from 10 am to 12:30 PM. Ken is proud that San Diego attorney John Demas will join him in presenting the seminar. Ken and John work together on many San Diego clients. John also has a 10 out of 10 rating on AVVO, and teaches both tax and real estate law at the University of San Diego.Ken’s recent seminars were overbooked, so please reserve early. For seminar reservations, or to book a consultation with Ken, call (818) 988-0949, or email [email protected].