United States: Estate Planning Hits Home When Residences Are Involved

Last Updated: September 4 2015
Article by Natalie M. Perry

Clients who jump into joint ownership of their homes to circumvent probate may land in unintended situations that other strategies could avoid.

With low interest rates causing many retirees to dip into their investment principal, and housing prices having risen since the economic downtown in 2008, practitioners may find that residential real estate comprises a large portion of some of their clients' estates. The illiquid nature of real estate however, can increase the difficulty of formulating estate plans that achieve client goals and objectives when the client's wealth is heavily weighted with real estate.

When planning with residential real estate, practitioners should first look to the title of the property. The method in which title is held may affect the type of planning that can be done with the property.

Tenancy choices

Generally, if a deed does not specify how title to real property is held, the owners are deemed to hold the property as tenants in common with equal interests. The default treatment when the type of tenancy is not specified may vary from state to state, especially for clients who are located in community property states. When title is held as tenants in common, upon the death of a co-owner, the interest passes under the deceased owner's estate plan or to his or her heirs-at-law. The interest does not pass automatically to the surviving owner or to the surviving owners.

If the deed states that the owners are to be treated as joint tenants, then each owner is treated as owning an undivided interest in the entire property. Joint tenants may have made unequal contributions to the property but each joint tenant is still treated as owning the entire property.

Joint tenancy can be severed by either joint tenant conveying his or her interest to another person. When an interest is held in joint tenancy, upon the death of a cotenant, the property automatically passes by law to the surviving co-owner regardless of the terms of the estate plan created by the deceased joint tenant. This is the primary difference between joint tenancy and ownership by tenants in common. Each joint tenant's interest terminates upon death.

Joint tenancy

An advisor may come across new clients who have titled or desire to title assets in joint tenancy as a means of avoiding probate. Elderly clients may have done internet research or spoken with friends who placed their residence in joint tenancy to avoid probate. These individuals may not realize the limitations of holding title in joint tenancy.

Although joint tenancy property will avoid probate, the client may find that other consequences of joint tenancy make this form of real estate ownership inappropriate for the client's individual situation. The following examples illustrate common situations where this occurs:

Example. An advisor meets with a client and discovers that the client's daughter is a joint tenant on the client's home. The client intends that the daughter divide the proceeds from the sale of the home after the client's death with her siblings. If the daughter follows these instructions, however, she will likely have made a taxable gift which could require her to pay gift tax if she already used her applicable estate and gift tax exclusion.

Example. Ann is an unmarried individual in her 70s with an estate of $1 million, of which $750,000 is the value of her home. She has two daughters, one of whom lives nearby and is caring for her; the other is situated a considerable distance away. Ann desires to place her home into joint tenancy with her daughter who resides locally. If Ann's will provides for assets to be divided equally among her children, and Ann intended this equality to apply to her entire estate, one of the daughters will receive a disproportionate share of the assets due to the residence passing to the surviving joint tenant.

In addition to the potential loss in value to other family members, there are several disadvantages to using joint tenancy to hold title to real estate. The primary disadvantages are as follows:

Loss of control. The consent of each co-owner is required in order to dispose of the property. Further, both parties' signatures are required to transfer or mortgage the property. If one joint owner refuses to participate in any of these transactions, the other owner would have to file a court action to sever the joint tenancy or force a sale of the property.

In the example above, if Ann wanted to sell her home, her daughter may disagree and refuse to sign the sale documents. Even if at the time of the creation of the joint tenancy, the daughter gave assurances that she would do whatever her mother asked with regard to the house, as time passes and circumstances change disagreements can arise unexpectedly even in the closest families.

Loss of creditor protection. Jointly held assets are fully available to the creditors of either joint tenant regardless of contribution. In order to satisfy a creditor's claim, a foreclosure could be initiated.

If Ann's daughter was sued by a creditor to recover a debt, Ann could lose her home if the home was the only asset available to satisfy her daughter's debt. If Ann's daughter had contributed some or all of the purchase price of the home to assist her mother financially, that investment could be at risk if Ann ran out of assets and needed to apply for public aid. If Ann is on the title to the residence as a joint tenant, then the entire value of the property would be a countable asset for purposes of determining Ann's eligibility for aid.

Tax consequences. As stated above, the creation as well as the termination of a joint tenancy interest can have gift tax consequences.1 When the sole owner of a personal residence places a nonspouse, such as a child, on the title to the individual's residence as a joint tenant, he or she has made an immediate gift of one-half the value of the property. For example, when Ann retitled her $750,000 home into joint tenancy with one of her daughters, Ann gave that daughter a $375,000 gift. The gift tax annual exclusion may shelter all or part of the gift. But if the gift is not fully sheltered, Ann would have to pay gift tax on the balance of the value transferred. Even if the exemption amount shelters the entire gift from tax, a gift tax return would need to be filed because the gift exceeds the annual exclusion amount.

The termination of a joint tenancy results in a taxable gift if the property itself or the proceeds from the sale of the property are not divided in accordance with the joint tenants' respective interests. In the example above, if the joint tenants agree to sell the residence but Ann retains all of the proceeds, Ann's daughter would have made a gift back to Ann of her interest in the property.

Tenancy by the entirety

Many states allow spouses to hold title to their residences as tenants by the entireties. Tenancy by the entirety (TBE) is very similar to joint tenancy in that when one spouse dies the other spouse inherits the entire property. When title is held in TBE, the residence cannot be attached by one spouse's creditor. This differs from joint tenancy where a creditor of either co-owner can attach the entire property. This makes TBE an attractive method of titling a residence for individuals in higher-risk professions such as physicians.

Some states allow TBE protection to couples who want to hold title to their home in TBE but through their revocable trusts. If TBE is used for trusts, the advisor should clarify with a local title company how the property will pass at death. This is an emerging concept in the law, and because the trusts are not individuals, the survivorship concept should be clarified prior to entering into such an arrangement. A couple who has entered into a civil union as well as same sex couples may also be able to hold title to their residence in TBE depending on the how the state of residency regards their marriage.

Disclaimers of real estate

A disclaimer can be a useful post-mortem planning tool to address a change in circumstances in a decedent's family or to modify an unintended transfer that occurred upon death. Most states allow a recipient of property to disclaim or renounce his or her right to receive property. The recipient of property may use a disclaimer to alter the distribution of property either for tax or nontax reasons. A disclaimer under state law will require that the disclaimer:

  1. Describe the property or the interest being disclaimed.
  2. Be signed by the individual making the disclaimer.
  3. Declare the disclaimer and the extent thereof.

If a valid disclaimer is made, the property passes to the next beneficiary or heir as if the individual who disclaimed had predeceased the decedent.

Generally, under state law a disclaimer can be made at any time. In order to avoid a transfer tax under federal tax law, however, the disclaimer must also satisfy the provisions of Section 2518. The Code's requirements contain a time limit that must be met for the disclaimer to be qualified.

Section 2518 prescribes the requirements for a disclaimer of property to be considered a "qualified disclaimer" and avoid transfer tax. In order to be a qualified disclaimer under the Code, the following requirements must be satisfied:

  1. The individual must not have accepted any benefit from the property.
  2. The written disclaimer must be delivered to the representative no later than nine months after the decedent's date of death or the date the individual turns age 21, whichever is later.
  3. The disclaimer must be irrevocable and unrestricted, and the property must pass without the direction of the disclaiming individual.

Disclaiming jointly owned real estate can be challenging. One common trap involves the issue of whether the individual disclaiming the property accepted the benefits from the property prior to disclaiming. The disclaimer rules prohibit a disclaimer if the individual making the disclaimer benefitted from the property.

Suppose a joint tenant is a spouse who resides in the property whose title then passes by operation of law to the surviving joint tenant immediately upon the death of the co-owner. By residing in the property, the spouse would seem to have accepted the benefits of the property after the decedent's death. However, Reg. 25.2518-1(d)(1) provides that a joint tenant does not lose the ability to disclaim merely because he or she continues to reside in the property before disclaiming the interest.

In the example above where Ann transferred property to only one of her two daughters, Ann's daughter could disclaim the property after her mother's death. If Ann's intention was not to give her daughter the entire property and the daughter makes a qualified disclaimer, then the property would pass as if Ann's daughter had predeceased her. If the daughter has children of her own, they would have to disclaim their interest (depending on their age) as well to get the property back to the mother's estate. The property would then pass according to the mother's will or by intestacy if no will had been executed.

QPRT

A qualified personal residence trust (QPRT) can be a tax-efficient way to transfer a personal residence out of an estate without making a large gift. A QPRT is an irrevocable trust that holds a personal residence for a term of years. At the end of the trust term, the residence is distributed to the beneficiaries named in the trust, who are often the client's children.

A QPRT is a "split interest trust" where the grantor creates a QPRT and retains the right to use and enjoy the property for a term of years and designates beneficiaries who will take the remainder interest. During the term of the QPRT, the grantor has the exclusive right to use, possess, and enjoy the residence without payment of rent. The term is selected by the grantor and the attorney drafting the QPRT. Because the gift is calculated by subtracting the present value of the grantor's retained interest, the taxable gift is significantly less than the fair market value of the entire property.

One of the sometimes-overlooked benefits of a QPRT is that is can be very useful for asset protection planning. Because a QPRT is an irrevocable trust and the residence does not belong to the donor after the transfer, the donor's creditors should not be able to execute a judgment lien against the residence.

The grantor's transfer of the residence to the QPRT results in a taxable gift. This gift does not qualify for the annual gift tax exclusion because the transfer of a personal residence to a QPRT is not a gift of a present interest. If the grantor dies before the trust term expires, the fair market value of the residence at the grantor's date of death will be included in the grantor's taxable estate. However, if the grantor used some of his or her exemption to shelter the initial gift to the QPRT, then the exemption will be restored to the grantor's estate as if the grantor had never created the QPRT.

If the grantor survives past the expiration of the trust term, the residence passes to the beneficiaries at the end of the term without additional transfer tax. If the grantor desires to continue residing in the residence, the grantor can lease the residence back from the beneficiaries at fair market rent. Note that the rental payments the grantor makes will reduce the value of his or her estate. Despite this perceived benefit, practitioners may find clients are not keen on paying rent to their children.

If the property is sold during the term of the QPRT, the proceeds can be reinvested in a new residence. If a new residence is not purchased or if the property ceases to be used as a personal residence, the trust ceases to qualify a QPRT and the trustee must distribute the assets outright to the grantor or convert to a grantor retained annuity trust.

Any gain recognized on the sale of a principal residence that has been transferred to a QPRT may qualify for the $250,000 (for married couples $500,000) exclusion from capital gain from the sale of a principal residence, provided all other requirements of Section 121 are met. The exclusion of gain does not apply to the sale of a property that is not a principal residence, such as a vacation home.

A grantor may establish a QPRT for no more than two residences. The trusts can be funded using a principal residence or a vacation home (or a fractional interest in either type of residence).

Practitioners should consider the client's life expectancy under the IRS tables when selecting the term of the trust. Because a longer term will decrease the value of the taxable gift, practitioners may find a longer term appealing to minimize the gift on creation. Although there is no limit on how long the term can be, the risk of the grantor surviving the term increases as the term increases.

One way to hedge against the possibility of a premature death with a QPRT structure is to have each spouse give a fractional interest in a residence. If the client is not married, he or she could create two QPRTs with terms of five and ten years, respectively. If the client dies after eight years, only the 50% interest attributable to the QPRT with the ten-year term is included in his or her estate. A gift of a fractional interest may also qualify for a discount, usually of no more than 10%.

If a married couple decides to create a QPRT, it is advisable for one spouse to transfer his or her share of the home to the other and have the spouses create two separate QPRTs. By creating two QPRTs, the clients can improve their odds of outliving the term by using two lives. The terms of the two QPRTs can be varied, especially if one spouse has had some health issues.

While a residence with a mortgage can be transferred to a QPRT, doing so can create issues and may minimize the benefits of using a QPRT. Where a residence subject to a mortgage is transferred to a QPRT, the gift is limited to the equity in the property and not the full market value. As subsequent principal payments are made on the mortgage, the grantor would be treated as making additional taxable gifts that would be measured by the same calculation method as the initial gift. To avoid future gift tax consequences, practitioners should recommend that clients transfer a residence to a QPRT that is not subject to a mortgage.

Joint purchase of real estate

A joint purchase of a parcel of real estate is an alternative to holding full title to the property in one individual or trust's name. It can also be a useful alternative to a standard QPRT. This type of ownership is different than joint ownership, which involves multiple current owners. In a joint purchase, the intended purchasers agree to divide the ownership so that one party's interest is limited to a term interest or a lifetime interest, and the other party owns the successor interest (after the term or after death). Title can be taken in the name of a trust that sets forth the split interest.

Section 2702 authorizes the use of a joint purchase but contains complex rules that must be followed. Section 2702 was enacted in 1990 in order to address what the IRS viewed as valuation abuses in transactions among family members where taxpayers transferred assets to reduce the size of the taxable estate and minimize gift tax. Chapter 14 includes Sections 2701 through 2704, which are intended to accelerate gift tax on certain transactions structured with family members designed to minimize transfer tax.

Section 2702 applies in the case of a transfer to a family member where the transferor retains an interest in the property. Section 2702 provides that if a taxpayer transfers property and retains an interest in the transferred property, the retained interest is not subtracted from the value of the transfer unless the retained interest is a "qualified interest" pursuant to Section 2702.

Section 2702 treats joint purchase (interests split between family members of different generations) as a taxable gift from the purchaser of the life or term interest to the purchaser of the remainder interest. The amount of the gift is the difference between the total value of the property and the amount paid by the holder of the remainder interest. Section 2702(c)(2) provides:

If 2 or more members of the same family acquire interests in any property described in paragraph (1) in the same transaction (or a series of related transactions), the person (or persons) acquiring the term interests in such property shall be treated as having acquired the entire property and then transferred to the other persons the interests acquired by such other persons in the transaction (or series of transactions). Such transfer shall be treated as made in exchange for the consideration (if any) provided by such other persons for the acquisition of their interests in such property.

Under this Section, when valuing the transferred property interest for gift tax purposes, the value of the retained interest is zero unless the retained interest is a qualified annuity or unitrust interest or an interest in a residence. Certain types of trusts are exceptions to the 2702 rules: a personal residence trust and a qualified personal residence trust. The main difference between these two trusts is that with a personal residence trust, the residence cannot be sold during the term and the trust is prohibited from holding proceeds of the sale.

If one of these exceptions is not met, this provision causes the transfer of the remainder interest to be valued for gift tax purposes at the same value as the entire property interest. For purposes of this provision, a family member includes:

  • The transferor's spouse.
  • An ancestor or lineal descendant of the transferor or the spouse.
  • Any sibling of the transferor.
  • The spouse of any such ancestor, descendant, or sibling.

Therefore, with a traditional joint purchase where the parent purchased the property and placed the remainder in the name of his or her children who provided no consideration, the parent, or life or term holder may have to pay a gift tax or use up some of his or her applicable exclusion.

The owner of the life interest in a joint purchase will have the right during the owner's lifetime to receive income from the property or to use, enjoy, and possess the property. A term interest gives the purchaser the right to receive income from or to use the property for a specified term. Upon the life holder's death or the expiration of the term, the holder of the remainder interest becomes the owner of the property without a taxable transfer taking place. Any increase in the value of the property is not subject to transfer tax.

The purchase price of the property must be allocated among the parties so that a proportionate share of the actuarial value of the property is paid directly by each purchaser. The IRS actuarial tables must be used to determine the value of each interest.

Example. Bill would like to purchase a vacation home in Florida listed for $1 million using a split-purchase structure. Bill is 65 years old and purchases a lifetime interest in the residence for $527,450 and is entitled to use and enjoy the property for his lifetime. Bill's son purchased the remainder interest in the residence from the seller for $472,500. Bill and his son use a QPRT structure for this transaction. Bill's purchase price is the present value of his interest in the property based on his actuarial life expectancy; his son paid the full value of the remainder interest.

When Bill dies, his interest terminates and his son becomes the owner of the residence. The value of the Florida property is not included in Bill's estate. If Bill's son was not able to purchase the remainder, a family trust for Bill's children could have been designated as the purchaser of the remainder interest.

Planning tip. To avoid gift tax liability, the parties to the joint purchase must show that each party paid fair market value for his or her share. If Bill's interest is not a qualified interest, then he will be considered to have made a gift to his son of the fair market value of the property less the actual amount paid by the son for his remainder interest.

Use of a trust. The joint purchase is often made using a trust. The trust could be in the form of a QPRT but issues can arise if the residence is sold before the death of the holder of the life interest.

Because the property passes directly to the purchaser of the remainder interest, the property would not be subject to a challenge by a potential beneficiary or a renunciation by a spouse. The asset would also not be available to the decedent's creditors.

Advantages over QPRT. Joint purchases have the following advantages over QPRTs:

  • No mortality risk. The interest in the residence should not be included in the estate of the life holder.
  • No requirement that rent be paid. Since the interest of the life holder can extend through death, there is no requirement that rent be paid.
  • No taxable gift. Because both parties paid their proportionate share of the purchase price, no gift occurs upon creation of the split interest. This can be a drawback if the remainder holder does not have sufficient funds to buy the remainder.
  • GST planning. There is no estate tax inclusion period (ETIP) with a joint purchase, so the purchaser of the remainder interest can be a skip person or a trust.

Drawbacks of joint purchase. In some respects, joint purchases have disadvantages not shared with QPRTs:

  • Cost. Under this arrangement, the remainder party has to come up with his or her own funds.
  • Loss of control. Permission from both the term holder and remainder holder are needed to sell property. The term holder and the remainder holder own consecutive interests in the property. The property, therefore, cannot be sold in fee simple without the consent of both parties.
  • Estate tax. If a joint purchase is structured and implemented so that the life or term holder pays the full present value of either the annuity or unitrust payments, then the property that is the subject of the joint purchase should not be taxable in the life or term holder's estate. However, in one private letter ruling, the IRS refused to rule on the application of Section 2036 to a split purchase arrangement.2 Most experts think the IRS would not succeed by arguing for inclusion under Section 2036.3 Because the property passes to the remainder holder by operation of law prior to or immediately upon the life or term holder's death, there is nothing to be included in the estate.
  • Limited to a new residence. This technique will not work for a residence that the client already owns.
  • Risk of outliving life estate. If the life tenant lives longer than expected, the remainder beneficiary will have overpaid for his or her interest and would have missed the opportunity to invest the funds in another manner.

Donating real estate to charity

Real estate may be used to accomplish a family's charitable giving goals. Although gifts of real property to charities are not nearly as common as gifts of cash, if the proposed donation is mutually beneficial, a donation of real estate can make sense. When donating real estate to a charity, the donor must use caution and ensure that the gift is structured in a tax-efficient manner.

A donor who holds appreciated property could avoid paying capital gains tax on the property by donating the property. The sale of the property in the charity's hands can generate substantial cash for the charity as long as there are no issues or unanticipated costs associated with the property.

Most charities operate on very tight budgets. Given their limited resources, a charity may not want to own real estate because the property could end up being more trouble than it is worth. Real estate ownership can create additional administrative concerns and expenses for the charity—such as insurance, taxes, and utilities.

Gifts of real estate (especially where a gift of a commercial property is contemplated) can pose special risks because of potential cleanup liability under the "Superfund" Clean-up Act. For this reason, practitioners may find that before a gift of real estate would be accepted, a charity will require that an environmental audit of the property be performed, likely at the donor's expense.

If an individual does donate real estate to charity, the charity will likely sell the property to raise cash for its charitable purposes unless the charity can use the real estate as its location or for programs. Despite these caveats, however, a charitable contribution of real estate can be advantageous in some situations.

Example. A married couple wishes to spend more time in a warmer climate, and they no longer have need for their vacation home in a ski resort. That home has no mortgage. They plan to sell the property and donate a portion of the proceeds to charity. The couple would recognize considerable gain on the sale and would have to pay a broker fee. Their advisor suggests they consider donating the home directly to their intended charity.

As long as the charity is a public charity, the couple can deduct the fair market value of the property donated.4 By donating the property directly to the charity, they would avoid recognizing capital gain and would receive a larger deduction. The property could also be gifted to a donor-advised fund. The charity that receives the real estate must be a public charity and not a private foundation. If the charity were a private foundation, the deduction would be limited to the donor's basis in the property. If the value of the property donated exceeds $5,000, the donor must obtain a qualified appraisal to support the amount of the deduction.

Caution should be exercised by the donor and the charity when the charity sells the property. One of the benefits of donating appreciated property to a charitable organization is that the donor will avoid paying capital gains tax. If the donor had entered into an agreement to sell the property, but then instead donates the property to a charity that completes the sale, the IRS could view the situation as a prearranged sale. In that event, the donor would be required to pay tax on the capital gain arising from the sale even though the charity sold the property and received the proceeds (instead of the donor).

Conclusion

When practitioners come across clients whose real estate holdings represent a large portion of their wealth, they should keep in mind that many options are available for planning with real estate. No one strategy fits all clients, but a variety of possibilities are available to select among and tailor to the needs of the particular client.

Footnotes

1. Reg. 25.2511-1(h)(5).

2. Ltr. Rul. 200112023.

3. See, e.g., Choate, The QPRT Manual (A Taxplan Publications, 2004), Chapter 1, page 54.

4. Section 170(b).

Previously published in Estate Planning - August 2015, Vol 42/ No 8

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.