In order to understand the value of these two trusts, you have to digest some background information about the federal estate tax, so we will start there.
Transfer Tax Guidelines
When you are planning your estate, you should inventory your assets so that you can determine whether or not you have any estate tax exposure. The line that separates those who must pay the tax from those that are exempt exists in the form of the federal estate tax credit or exclusion.
During the 2019 calendar year, the exact amount of the federal estate tax credit or exclusion is $11.4 million. This is the amount that can be transferred to your heirs free of taxation. Anything that you intend to transfer that exceeds this amount is potentially subject to the death tax and its 40 percent maximum rate.
We also have a federal gift tax that applies to large gifts that you give while you are living. The $11.4 million exclusion encompasses lifetime gifts along with the value of the estate that you are passing on to your heirs.
Qualified Personal Residence Trusts
When you are determining the value of your estate, you must include the value of your home. If you could reduce its taxable value, you would be mitigating your estate tax exposure. This could be done through the creation of a qualified personal residence trust.
Here’s how it works. You fund the trust with the home, and you name a beneficiary who will inherit the home after the term of the trust expires.
You decide on the length of the term when you are creating the trust agreement, and you continue to reside in the home rent-free during this interim. It is referred to as the “retained income period.”
Funding the trust with the home removes it from your taxable estate. However, because the beneficiary will be assuming ownership of the home after the conclusion of the trust term, the act of funding the trust is considered to be an act of taxable gift giving by the Internal Revenue Service.
The retained income period reduces the taxable value of the gift. If you were to sell the home on the open market, no buyer would pay full market price if he or she could not assume ownership of the property for a number of years. The IRS takes this into account when the taxable value of the gift is being determined.
After the term expires, the beneficiary assumes ownership of the home, but the tax that is levied on the transfer is based on a home value that is far less than the true market value of the property.
The longer you stay in the home, the better from a tax perspective. However, if you die before the term expires, the home goes back into your taxable estate. You should consider this when you are deciding on the duration of the retained income period.
Irrevocable Life Insurance Trust (ILIT)
Insurance policies can be part of your taxable estate if you directly own them during your life and have control over their cash value. To account for this, you could establish an irrevocable like insurance trust or ILIT.
When you place your insurance policies into an irrevocable life insurance trust, you are removing the policies from your taxable estate. However, there is a three-year rule. You must live for at least three years after transferring the policies into the irrevocable life insurance trust. If you pass away within three years of conveying the policies into the trust, they would once again become part of your taxable estate.
In the trust agreement you name a trustee to administer the trust, and you name a beneficiary. You may assume that you should make your spouse the beneficiary of the trust, but there is a reason why you may want to go in another direction.
Let’s say that you want to provide for your spouse, but you ultimately want your children to inherit the insurance policy proceeds. If you make your spouse the beneficiary, he or she would be in direct personal possession of the proceeds. The estate tax would be a factor when your surviving spouse is passing along his or her legacy to your children.
To account for this you could make the trust the beneficiary. When you draw up the trust agreement, you can leave instructions for the trustee to follow. You could instruct the trustee to distribute resources to your spouse, but he or she would never directly own the assets. As a result, the estate tax would not be applicable upon the death of your surviving spouse.
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