A House And A Specialized Trust

I saw a QPRT here at Galactic Command recently,

It had been a while. These things are not as common in a low interest rate environment.

A QPRT (pronounced “cue-pert”) is a specialized trust. It holds a primary or secondary residence and – usually – that is it.

Why in the world would someone do this?

 I’ll give you a common example: to own a second home.

Let’s say that you have a second home, perhaps a lake or mountain home. The children and grandchildren congregate there every year (say summer for a lake home or the holidays for a mountain home), and you would like for this routine and its memories to continue after you are gone.

A couple of alternatives come immediately to mind:  

(1)  You can bequeath the property under will when you die.

(2)  You can gift the property now.

Each has it pros and cons.

(1) The property could continue to appreciate. If you have significant other assets, this appreciation could cause or exacerbate potential estate taxes down the road.

(2) You enjoy having and using the property and are not quite ready to part with it. You might be ready years from now - you know: when you are “older.”

A QPRT might work. Here is what happens:

(1) You create an irrevocable trust.

a.    Irrevocable means that you cannot undo the trust. There are no backsies.

(2) You transfer a residence to the trust.

a.    The technique works better if there is no mortgage on the property. For one thing, if there is a mortgage, you must get money into the trust to make the mortgage payment. Hint: it can be a mess.

(3) You reserve the right to use the property for a period of years.

a.    This is where the fancy planning comes in.

b.    It starts off with the acknowledgement that a dollar today is more valuable than a dollar a year (or years) from now. This is the “time value of money.”

c.    At some point in time the property is going to the kids and grandkids, but … not … right …now.     

d.    If the property is worth a million dollars today, the time value of money tells us that the gift (that is, when the property goes to the kids and grandkids) must be less than a million dollars.  

e.    There is a calculation here to figure out the amount of the gift. There are three key variables:

                                               i.     The age of the person making the gift

                                             ii.     The trust term

                                           iii.     An interest rate

A critical requirement of a QPRT is that you must outlive the trust term. The world doesn’t end if you do not (well, it does end for you), but the trust itself goes “poof.” Taxwise, it would be as if you never created a trust at all.

(4) There is a mortality consideration implicit here. The math is not the same for someone aged 50 compared to someone aged 90.

(5) Your retained right of use is the same thing as the trust term. You probably lean toward this period being as long as possible (if a dollar a year from now is worth less than a dollar today, imagine a dollar ten years from now!). That reduces the amount of the gift, which is good, but remember that you must outlive the trust term. There is push-and-pull here, and trust terms of 10 to 15 years are common.

We also need an interest rate to pull this sled. The government fortunately provides this rate.

But let’s go sidebar for a moment.

Let’s say you need to put away enough money today to have $5 a year from now. You put it in a bank CD, so the only help coming is the interest the CD will pay. Let’s say the CD pays 2%. How much do you have to put away today?

·      $5 divided by (100% + 2%) = $4.90

OK.

How much do you have to put away if the CD pays 6%?

·      $5 divided by (100% + 6%) = $4.72

It makes sense if you think about it. If the interest rate increases, then it is doing more of the heavy lifting to get you to $5. Another way to say this is that you need to put less away today, because the higher interest is picking up the slack.

Let’s flip this.

Say the money you are putting in the CD constitutes a gift. How much is your gift in the first example?

$4.90

How much is your gift in the second example?

$4.72

Your gift is less in the second example.

The amount of your gift goes down as interest rates go up.

What have interest rates been doing recently?

Rising, of course.

That makes certain interest-sensitive tax strategies more attractive.

Strategies like a QPRT.

Which explains why I had not seen any for a while.

Let me point out something subtle about this type of trust.

·      What did we say was the amount of the gift in the above examples?

·      Either $4.90 or $4.72, depending.

·      When did the gift occur?

·      When the trust was funded.

·      When do the kids and grandkids take over the property?

·      Years down the road.

·      How can you have a gift now when the property doesn’t transfer until years from now?

·      It’s tax magic.

But what it does is freeze the value of that house for purposes of the gift. The house could double or triple in value before it passes to the kids and grandkids without affecting the amount of your gift. That math was done upfront and will not change.

A couple of more nerd notes:

(6) We are also going to make the QPRT a “grantor” trust. This means that we have introduced language somewhere in the trust document so that the IRS does not consider the QPRT to be a “real” trust, at least for income tax purposes. Since it is not a “real” trust, it does not file a “real” income tax return. If so, how and where do the trust numbers get reported to the IRS? They will be reported on the grantor’s tax return (hence “grantor trust”). In this case, the grantor is the person who created the QPRT.

(7)  What happens after 10 (or 15 or whatever) years? Will the trust just kick you out of the house?

Nah, but you will have to pay fair-market rent when you use the place. It is not worst case.

There are other considerations with QPRTs – like selling the place, qualifying for the home sale exclusion, and forfeiting the step-up upon the grantor’s death. We’ll leave those topics for another day, though.

Using A Liquidating Trust

I am reading a case where the IRS wanted taxes of almost $1.5 million.

I am not surprised to read that it involved a real estate developer.

Part of tax practice is working within someone’s risk tolerance (including mine, by the way). Some clients are so risk adverse that an IRS notice – on any matter for any reason – can be interpreted as a mistake by the tax practitioner. Then you have the gunslingers at the other end of the spectrum. These are the clients you have to rope-in, for their own as well as your sake.

My experience has been that real estate developers seem to cluster around the gunslinger end of the spectrum. We have one who recently explained to me that “paying taxes means that the tax advisor made a mistake.” That, folks, is a lot of pressure … on my partner.

Jason Sage is a developer in Oregon. He represented several companies, including JLS Customs Homes. You may recall that 2008 – 2009 was a rough time for real estate, and JLS took it in the teeth. It had three projects, dragging behind approximately $18 million in debt.

Eventually the real estate market collapsed. Sage had to do something. He and his advisors decided to utilize liquidating trusts. The idea is that one transfers everything one has into a trust, which might be owned by one’s creditors; then again, it might not. The creditors might accept the settling of the trust (a fancy term for putting money and assets into a trust) as discharge of the underlying debt; then again, they might not. Each deal is its own story, and the tax consequences can vary depending on the telling.

Our story involves the transfer of three projects to three liquidating trusts. Since real estate had tanked, these transfers – treated for tax purposes as sales - threw off huge losses. These losses were so big they created overall losses - called “net operating losses” (NOLs). Tax law at the time allowed the net operating losses to travel back in time, meaning that Sage could recoup taxes previously paid.

COMMENT: I see nothing wrong with this. If the government wants to participate in one’s profits, then it can also participate in one’s losses. To do otherwise smacks more of robbery than taxation.

The IRS took a look at this arrangement and immediately called foul.

Trust taxation looks carefully at whether the trust is a separate tax entity from the person establishing the trust, funding the trust or benefiting from the trust.  There is a type called a “grantor trust” which is disregarded as a separate tax entity altogether. The most common type of grantor trust is probably the “living trust,” which has gained popularity as a probate-mitigating tool. The idea behind the grantor trust is that the grantor – say me, for example – is allowed to put money in, take money out, change beneficiaries, even terminate the trust altogether without anyone being able to gainsay my decision.

Tax law considers this to be too much control over the trust, so the trust and I are considered to be the same person for tax purposes. I would have a grantor trust. Its tax return is combined with mine.

How do I avoid this result? Well, I have to start with limiting my otherwise unrestricted control over the trust. Yield enough control and the IRS will respect the trust as separate from me.

The IRS argued that Sage’s liquidating trusts were grantor trusts. They were not separate tax entities, and one cannot sell and create a loss by selling to oneself. Without that loss, there was no NOL carryover and therefore no tax refund.

Sage had to persuade the Court that the trusts were in fact separate from him and his companies.

After all, the trusts were for the benefit of his creditors. One has to concede that creditors are an adverse party, and the existence of an adverse party is an indicator that the trust is a separate tax entity. Extrapolating, the existence of creditors means that someone with interests adverse to Sage’s own had sway over the trusts. It was that sway that made these non-grantor trusts.

Persuasive, except for one thing.

Sage had never involved the creditors when setting up the trusts.

It was hard for them to be adverse when they did not even know the trusts were there.

Our case this time was Sage v Commissioner.

Grantor Retained Annuity Trusts In 2020

I was glancing over selected IRS interest rates and one caught my attention.

The Section 7520 rate for June, 2020 is 0.6%.

There are certain tax tools that work well in times of low interest rates. One is a grantor retained annuity trust, commonly referred to as a “GRAT.” One associates them with the fancy-pants rich, but I am thinking they can have broader appeal when the triggering interest rate is 0.6%.

Let’s talk about it. We will keep the discussion general as otherwise we would be going into a math class. Our purpose today is to understand what makes this tax tool work and why 2020 – with low interest rates and declining stock prices – are a perfect setup for a GRAT.

First, a GRAT is an irrevocable trust. Irrevocable means no take-backs.

A trust generally has three main players:

(a)  The settlor; that is, the moneybags who funds the trust. Let’s say that is me (CTG)

(b)  The trustee. That will be you.

(c)  The beneficiaries., There are two types:

a.    Income. For now, that will be me (CTG) as I receive the annuity.

b.    Remainder. That will be my grandkids (mini-CTGs), because they receive what is left over.

This trust will be taxed to me personally rather than pay taxes on its own. The nerd term for this is “grantor’ trust.

I fund the trust. Say that I put in $50 grand.

The trust will then pay me a certain amount of money for a period of time. Let’s say the amount is $10,000, and the trust will pay me for two years. I am retaining an annuity from the trust.

COMMENT: Truthfully, I think it would take at least 2 years to even qualify as an “annuity.” One payment does not an annuity make.

When the trust runs its course (two years in our example), whatever is left in the trust goes to the mini-CTGs.

If you sweep aside the details, you can see that I am making a gift to my grandkids. The GRAT is just a vehicle to get there.

Why bother?

Say that I just give $50 grand to my grandkids or to a trust on their behalf.

I made a gift.

Granted, I am not worried about gift tax on $50 grand given the current lifetime gift tax exemption of $11.5 million, but if someone moves enough money there can be gift tax.

Let’s say you can move enough money.

Congrats, by the way.

Is there a way for you to gift and also minimize the amount of gift tax?

Yep. One way is the GRAT.

Here is how the magic happens:

(1)  The tax Code backs into the amount of the gift. It does this by placing a value on the annuity. It then subtracts that value from the amount transferred into the trust ($50 grand in our example). The difference is the gift.

(2)  How can I maximize the value of the annuity?

a.    I want $10 grand. If I could get 5% interest, I would need $200,000 grand to generate that $10 grand.

b.    But I cannot get 5% in today’s economy. I might get lucky and get 1.5%. To get $10 grand, I would have to put in $666,667, which is a whole lot more than $200,000.

c.    This example is far from perfect, as I what I am describing is closer to an endowment than to an annuity. The takeaway however is valid: I have to put more money into an annuity as interest rates go down if I want to keep the payment steady.  

(3)  How does this affect the gift?

a.    Had I created the GRAT in June, 2018, I would have used a Section 7520 rate of 3.4%.

b.    It would require less money in 2018 to fund a $10,000 payment, as the money would be earning 3.4% rather than 0.6%.

c.    Flipping (b), it would require more money in 2020 to fund a $10,000 payment at 0.6% rather than 3.4%.

d.    As the value of the annuity goes up, the value of the gift goes down.

Let’s express this as a formula:

Gift = initial funding – value of annuity

e.    As the value of the annuity increased in 2020, the gift correspondingly decreased.

f.     That is how low interest rates power the GRAT as a gifting technique.

How do declining stock prices play into this?

Let’s look at Boeing stock.

Around March 1^st Boeing was trading at approximately $275.

As I write this Boeing trades around $120.

Now, I do not want to get into Boeing’s story, other than this: let’s say you believe that Boeing will bounce back and bounce much sooner than eternity. If you believe that, you could fund the GRAT with Boeing stock. The mathematics will be driven-off that $120 stock price and Section 7520 rate of 0.6%.

What happens if you are right and the stock returns to $275?

Your annuity is unchanged, your gift is unchanged, but the value of Boeing stock just skyrocketed. Your beneficiaries will do very well, and there was ZERO added gift tax to you.

Another way to say this is that you want to fund that GRAT with assets appreciating at more than 0.6%.

Folks, that is a low bar.

There however be dragons in this area.

You could fund the trust and the assets could go down in value. It happens.

Or you could die when the trust is still in existence. That would pull the trust back into your estate.

Or the trust becomes illiquid and you start pulling back assets rather than cash. That is a problem, as the assets appreciating is part of what powers this thing.

Then there are variations on the payment. One could specify a percentage rather than a dollar amount, that way the dollar amount of the annuity would increase as the assets in the trust increase.

There is a technique where one uses the annuity to fund yet another GRAT. It is called a “rolling” GRAT, and it worked when interest rates were much higher.

BTW, there is a twist on a GRAT, and it involves working the math so that the gift comes out to exactly zero. One might want to do this if one has run out of lifetime exemption, for example. The tax nerds refer to it as a “Walton” GRAT, in honor of Audrey Walton, wife of Wal-Mart cofounder Bud Walton. It took a court case to get there, but the technique has thereafter assumed the family name.

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.