Friday, June 20, 2014

The Clintons And Their Residence Trusts

I am looking at a Bloomberg article titled” Wealthy Clintons Use Trusts to Limit Estate Tax They Back.”

I get the hypocrisy. There truly cannot be any surprises left with this pair, but I get it.

I also have no problem with the tax strategy. I would use it unapologetically, if I were within its wheelhouse.

This trust is known as a Qualified Personal Residence Trust (QPRT), pronounced “cue-pert.” I use to see more of them years ago, as this trust works better in a high interest rate environment. We haven’t had high interest rates for a while, so the trust is presently out of its natural element.

You can pretty much deduce that this trust is funded with a house. It can be funded with a main residence or a second home. I have seen it done with (very nice) vacation homes. There are income tax and gift tax consequences to a QPRT. 

Let’s go through an example to help understand the hows and whys of this thing.

Let’s say that we have a modestly successful, low-mileage, middle-aged tax CPA. We shall call him Steve. Steve owns a very nice second home in Hailey, Idaho. Word is he bought it from Bruce Willis. Steve and Mrs. Steve are meeting with their tax advisor, and they are discussing making gifts to their children. The advisor mentions gifting the Hailey residence, using a QPRT.

Mrs. Steve: How does that work?
Advisor:      The house is going to go the kids eventually, someday. We are just putting it in motion. We set up a trust. We put the house in the trust. We have the trust last a minimum number of years – in your case, maybe 15 years. At the end of the trust, the house belongs to the kids. Maybe it belongs to a trust set up for the kids. You can decide that.
Mrs. Steve: What’s the point? In any event the kids will wind up with house anyway.
Advisor:      The point is to save on estate and gift taxes. Someday this house will pass to the kids. If it happens while you are alive, we have to discuss gift taxes. If it happens at your or Steve’s death…
Steve:         I am right here, people.
Advisor:      Just explaining the process. If it happens at death, we have to discuss estate taxes.
Mrs. Steve: So, either way …
Advisor:      … you are hammered.
Mrs. Steve: How do I save money?
Advisor:      You continue to live in the house for a while, say fifteen years. The house is eventually going to the kids, so there is a gift. However the house is not going to the kids for fifteen years, so the value of the gift is the house fifteen years out.
Mrs. Steve: Wait. The house will be worth more fifteen years out. How is this possibly helping me?
Advisor:      I said it wrong. The IRS considers the gift to be made today for something to be delivered fifteen years out. That long wait reduces the value of the gift, which is what drives the gift tax planning with a QPRT.
Mrs. Steve: Should I just invite the IRS to an audit?
Advisor:      Not at all. We can find out what the house is worth today. The IRS has given us tables and interest rates to calculate the fifteen years wait. Since we are using their tables and their rates, it is fairly safe mathematics. There isn’t much to audit.
Steve:         I am stepping out to stretch my legs.
Mrs. Steve: Give me an example.
Steve:         Is there fresh coffee in the break room?
Advisor:      We have seen cases where someone has transferred a house worth $2 million in a ten-year QPRT and the IRS says the gift was only around $550 thousand.
Mrs. Steve: Which does what?             
Advisor:      You get to hold on to your lifetime gift tax exemption as long as possible. You can make more, or larger, gifts and not owe any gift tax as long as you have some lifetime exemption amount remaining.
Mrs. Steve: Who pays for the house; you know, the utilities, the maintenance, taxes and all that?
Advisor:      You do. And Steve, of course.
Steve:         (from outside the room) Did I hear my name?
Mrs. Steve: No! Go find your coffee.  
Mrs. Steve: Who gets to deduct the real estate taxes – the trust?
Advisor:      The trust is “invisible” for tax purposes. It is a “grantor” trust, which means that – to the IRS – there is no trust and it is just you and Steve. You get to deduct the real estate taxes.
Mrs. Steve: Wait a minute. If there is no trust, how can there be a gift?
Advisor:      This part gets confusing. For income tax purposes, the IRS says that there is no trust. For gift tax …
Steve:         (from outside the room) Where’s the cream?
Advisor:      For gift tax purposes, the IRS says there is a trust. Because there is a trust, you can make a gift.
Mrs. Steve: You are kidding.
Advisor:      No. Tax law can be crazy like that.
Mrs. Steve: What happens if after fifteen years I still want to live there? Does the trust boot me out?
Advisor:      Nope. You can rent the house, but you will have to pay fair market value, of course.
Mrs. Steve: Because I no longer own it.
Advisor:      Right. Also, since you do not own it, technically the kids could act against you and sell the house, even if against your will. That is a reason for keeping the house in some kind of trust, even after the QPRT term, as it allows for an independent trustee.
Mrs. Steve: What is the downside to this QPRT thing?
Steve:         (walking back into room, with coffee) We done yet?
Advisor:      You have to outlive the trust.
Steve:         I intend to. What are you talking about?
Advisor:      If the QPRT is for fifteen years, then you have to live at least fifteen years and a day for this thing to work.
Steve:         And if I don’t?
Advisor:      It will be as though no trust, no gift, no anything had ever happened. The house would be pulled back into your estate at its value when you die.
Steve:         Why do I keep dying with you two?
Mrs. Steve: OK. Steve dies before fifteen years. What can I do to minimize the risk to me of him dying….
Steve:         Risk to you?
Mrs. Steve:  … of him dying before his time?
Advisor:      Several things. You and Steve own the house jointly, right?
Mrs. Steve: Of course.
Steve:         (under his breath) As though there was a choice.
Mrs. Steve: What was that, dear?
Steve:         Just blowing on the coffee to cool it down, dear.
Advisor:      We set up two trusts. One for Steve and one for you. It helps with the odds.
Mrs. Steve: I like that.
Advisor:      We can even “supercharge” that by putting fractional interests in the trusts. Say you put a 1/3 fractional interest each. You and Steve would be able to fund six different trusts. We could vary the term of the trusts – say from ten to twenty years – again improving your odds.
Steve:         Are we still talking about me?
Mrs. Steve: It’s not about you, dear.

Believe it or not, this is pretty straightforward and well-marked tax planning for folks who know they will be subject to the estate tax. Few planners would describe QPRTs as aggressive. There are some twists and turns in there – say if the trust sells the house during the trust term, for example – but that can be a blog for another day.

How and why would the Clintons be pursuing this strategy? Remember that they own two houses: one in Washington (worth approximately $2 million) and another in Chappaqua, New York (worth approximately $5 million). They have quite a bit of money tied-up there. They are almost certain to face an estate tax some day, bringing them well within the wheelhouse of a QPRT.

Not bad for dead broke.

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