DonŐt overlook your home in your tax strategy

The substantial tax savings from putting your residence in trust could help preserve the business.

By Barton L. Kaufman and Kristin D. Wheeler

For years, countless business owners reduced estate taxes for their heirs through well-known estate-freeze strategies. By making lifetime gifts in trust to his children, a business owner effectively removed from his estate any future appreciation in his business interest, while continuing to enjoy control and income from the business. Other valuable assets, such as a home, also figured in the overall tax planning needed to preserve the family's most important asset — the family business.

Recent Federal Tax Code changes attached conditions to most estate-freezing techniques, making these strategies much less attractive. But a few freezing techniques survived and still produce substantial tax savings. One often overlooked technique is the "residential GRIT" (Grantor Retained Interest Trust), which enables an owner to gift his home and freeze its value for tax purposes while retaining the right to live in it for a specified number of years.

To establish a residential GRIT, a taxpayer (grantor) transfers title to an irrevocable trust and pays gift tax based on the home's value at the time; the length of time the grantor plans to continue living in the home; the grantor's age at the time of the trust's formation; the property value's projected appreciation (figured from sales of comparable real estate in recent years), and a rate issued monthly by the Treasury, which is used with IRS tables in valuing the interest retained or gifted by the grantor (it was 8.2 percent for July, 1992).

If the grantor survives the term of the trust, his savings on estate taxes can be tremendous. Consider, for example, a woman named Vera who owns a $2 million residence that has appreciated annually at about 5 percent. Vera wants to transfer the home to her children, but also wants to continue to live there until her death. She is 72 years old and, according to standard actuarial tables, has a life expectancy of 85 years, or another 13 years.

If Vera creates a residential GRIT with a term of 10 years, she makes a gift worth $528,425 (when all of the above-mentioned factors are considered). Assuming a gift tax rate of 38 percent, she will pay $200,802 in taxes, and in the 10th and final year of the trust, title to the home will pass to her children.

If Vera lives another 13 years, at her death the home will have an appreciated value of $3,771,298. Her heirs will owe no estate tax on the home (because the property no longer belonged to her), and Vera will have successfully transferred the house to her children for $200,802 in gift tax. If she had not used a GRIT, the estate tax on the home would have come to $1,100,000. But since she did use a GRIT, even if Vera had already claimed her $600,000 unified credit (the combined exemption allowed from gift and estate taxes), she would have saved her heirs a total of $899,198.

In the chart below, note that the taxable value of a gift increases with the age of the grantor but decreases with the length of the trust. The longer the trust term, the greater the tax savings. For example, using the $100,000 increments shown in the chart, a 65-year-old grantor who conveys a $1 million residence to his children in a 10-year trust will have a taxable gift of $334,950. But if he increases the term to 15 years, he will pay tax on a gift of only $171,700. He cuts his tax in half by increasing his risk to include another 5 years. If a 75-year-old grantor with the same home stretches his GRIT term from 10 to 15 years, he reduces his gift tax by two-thirds.

In addition to freezing an asset's value for substantial tax savings, a residential GRIT allows a grantor to "leverage" his unified credit. For instance, if Vera in the example above has not previously used more than $71,575 of her $600,000 unified credit, she would owe no gift tax at the GRIT's execution; there would also be no estate tax on the home at her death. (Incidentally, because of proposed legislation, it may make even more sense now to use one's unified credit sooner rather than later: Some Congressmen have supported financing a national health insurance plan by reducing the unified credit amount from $600,000 to $200,000.)

Let's then assume that Vera also has a $2 million cosmetics business that she wants to pass on to her son and daughter. If the business appreciates at just 5 percent, the business's projected taxable value at her death would be $3,771,298, which results in a marginal federal estate tax rate of 55 percent. These taxes could easily jeopardize the business's future.

But because Vera saved nearly $900,000 using a GRIT, her heirs will have more funds with which to cover estate taxes on the business, and a liquidation is therefore less likely. Also, the business will be taxed at a lower rate because Vera's home was not in her estate and so did not push up the marginal estate tax rate.

What are the risks of using a residential GRIT? If the grantor does not survive the trust period, then the home's entire value is included in his estate. However, the grantor can counterbalance the risk of dying before the term's end — while maximizing the benefits of the GRIT — by purchasing life insurance. The policy on the grantor's life for the trust period protects his estate by providing funds for any unexpected estate taxes from the residence.

Finally, a grantor not only designates how long he plans to continue in the home, he also chooses the trust's length. The GRIT can terminate when his retained term (say, 10 years) ends, and the house then goes outright to the beneficiaries. Or the house can continue in trust for the beneficiaries even after the grantor's retained interest has ended. Under either arrangement, the grantor's legal right to remain in the home ends when his retained term interest is over.

But what if the grantor outlives his retained term? To re-establish his legal right to possession, he can buy back the home from the beneficiaries (who avoid capital gains if the home remained in trust for them). Or, if the home continues in trust, he can rent from the trust, thereby transferring additional wealth to his children without paying more in gift tax.

Residential GRITs offer an opportunity that should not be overlooked by family business owners who want to prevent taxes from forcing their heirs to sell the business. The risks of using a residential GRIT to best advantage are minor and can be eliminated by insuring the trust's term.

Reduced transfer costs from using a residential GRIT

(Taxable amounts for each $100,000 in value of residence)
GRIT duration in years