Real estate is not only the most significant asset many people transfer to their heirs, but also the most complicated aspect of an estate plan. The legacy of a family residence or vacation home can have major investment and tax implications.
Property owners are facing pressure to firm up wealth-transfer strategies to take advantage of a US$12.92 million per-person estate-tax exemption, which is scheduled to expire after 2025. The current exemption, which amounts to US$25.84 million per couple, is the highest ever and was passed under the Tax Cuts and Jobs Act of 2017 with a built-in sunset, after which the exemption returns to its 2017 level of US$5.5 million, adjusted for inflation.
Given a strong appreciation in real estate values in recent years and the looming drop in the estate-tax exemption, even folks who do not consider themselves high-net-worth will have to get strategic to minimize the tax impact of their wealth transfer, says Jason Thompson, chief wealth strategist at Rockefeller Global Family Office.
If you expect your property will continue to appreciate, it can be a big advantage to transfer ownership during your lifetime, Thompson says. “Once you make a gift, you have removed it from your estate at its current value, along with all of the future appreciation,” he says.
Even better is if you can transfer property at a discounted valuation so that the gift uses up less of your estate-tax exemption, he says.
Rising interest rates over the past year have improved the effectiveness of a couple of estate planners’ favorite types of irrevocable trusts that enable discounted wealth transfers.
"These trusts can’t be amended, and they should raise questions about whether you have enough liquidity in your own name,” Thompson says. “But from a tax-strategy standpoint, these are good planning tools.”
Consider the so-called Qualified Personal Residential Trust (QPRT), a tool often used by folks who want to transfer their property’s ownership but also want to continue living in the home.
“We haven’t used the strategy for about a decade, but now that interest rates have come back up, a lot of planners are pulling it out of the tool kit,” says Justin Flach, managing director for wealth strategy at U.S. Bank Wealth Management.
A QPRT, which can be used to transfer a primary home and one vacation property, is a way to remove the asset from your estate during your lifetime at a discounted valuation, while still living in the property for at least the term of the trust.
The owner gifts a property to the trust, and at the end of the term the property title is transferred to the trust’s beneficiaries.
The value of the property for gift and estate-tax purposes is not the current value of the home. Rather, it is the actuarial value of the owner’s remainder interest in the property at the end of the trust’s term. The longer the term of the trust, the lower the actuarial value and the better the wealth-transfer tax impact.
During the trust’s term, the owner continues to pay property expenses and can continue to live in the property. Once the term is up, if the owner wants to continue living in the property, a rental agreement must be established, and rent must be paid to beneficiaries.
The risk with these trusts is that the owner dies before the term is up, Flach says. If this happens, the trust dissolves and the ownership of the home returns to the estate.
A second type of irrevocable trust that shines when interest rates are high is for folks who want to leave a property—whether a personal residence or investment property—to charity: a charitable remainder trust (CRT).
The owner may not continue living in the home, but receives an annuity payment for the trust’s term. In the year the trust is established, the owner can take a tax deduction equal to the value of the property at the end of the trust’s term.
While these strategies can be highly effective for tax minimization, it is generally not advised to purchase property as a means to transfer wealth. Whether or not to buy property is an investment question, not an estate-planning question, Flach says. “You have to look at your overall portfolio and ask if a property is the right asset to put into your investment mix.”