Estate Planning With Personal Use Real Estate

• Published date: 06 October 2022
• Subject Matter: Real Estate and Construction, Family and Matrimonial, Estate Management, Real Estate, Wills/ Intestacy/ Estate Planning
• Law Firm: Ivins, Phillips & Barker
• Author: Ms Leslie Wood Bradenham

The looming threat of a reduction in the lifetime exemption from Federal estate and gift taxes, either due to sunsetting January 1, 2026 or sooner via affirmative legislative action, has resulted in most high-net-worth clients exploring ways to use their entire $12.06 million exemption before it is cut in half. But even for the very wealthy, $12.06 million is a substantial sum with which to part. As a result, many clients have been exploring how to use their exemptions without giving away liquid assets, and real estate is a natural choice. Gifting personal use real estate can be complex and requires careful navigation of estate and gift tax rules, but it can be a good option for some clients.

Gifting the Entire Interest

The Basics

A donor can simply gift her entire interest in a residence outright to one or more children or other beneficiaries. Alternatively, a donor can gift the real estate to a trust for the benefit of children and more remote descendants (or others). Gifts in trust can be beneficial for a variety of reasons, including protection from the claims of creditors, removal of assets from the beneficiaries' taxable estates, and removal of assets from the reach of the generation-skipping transfer (GST) tax. In either case, if the client gifts a 100% interest in mortgage-free real estate, the gift transfer itself is straightforward. A current fair market value real estate appraisal will be required to substantiate the value of the gift, a real estate deed transferring the property to the recipient individual or trust must be prepared and properly recorded, and a gift tax return will be required to report the transaction. Clients should be advised regarding real estate transfer and deed recordation taxes that could apply, but in most states there is an exemption for gift transfers.

Continued Donor Occupancy

If the donor wishes to continue occupying the home, the transaction becomes more complicated. Payment of fair market value rent will typically be required. This is because, pursuant to IRC ' 2036, property given away during a client's lifetime will be included in the client's taxable estate if he retains a continued right to the income or enjoyment of the property. To avoid this result, in most circumstances we advise the client to enter into a written lease agreement with the donee and pay fair market value rent, as established by an independent appraisal. This appraisal is important not only to substantiate that full value is being paid, and thus no rights are retained that would trigger estate inclusion under IRC ' 2036'but also to ensure that the client is not paying too much in rental payments, thereby risking an argument that additional, disguised gifts are being made.

Not only is a formal written lease the best practice for avoiding estate and gift tax issues, it is also an efficient way to transfer additional wealth to beneficiaries. The lease payments are not taxable gifts when made and reduce the value of the donor's estate for estate tax purposes. Moreover, if the real estate was gifted to a trust that is classified as a "grantor trust" for income tax purposes, the rental income received by the trust is not subject to income tax.

While leaseback of the gifted residence is almost always recommended for the reasons discussed above, where the real estate is gifted to a trust for which the grantor spouse is a beneficiary'often referred to as a "Spousal Lifetime Access Trust" or a "SLAT"'rental payments are likely unnecessary. The theory is that the grantor spouse's continued use of the property with the beneficiary spouse is a "natural incident to the marital relationship".¹ Therefore, the rent-free use of the property together with the donee spouse after the gift does not itself give rise to an implied agreement that the donor has retained the right to use...