There may come a day when you decide to transfer your home to your children or other relatives. Once the home is legally out of your hands, it is removed from your taxable estate. But there's a problem: You still need a place to live and you could be hit with a hefty gift tax on the home's value.
One possible solution is to set up a
"personal residence trust." With this type of trust, the donors technically make a gift of the home now-it's called a
"remainder" interest-but you don’t actually transfer the home until years down the road. In the meantime, you continue to live in the home as before. Best of all, there's no estate tax due on the transfer and the gift tax is a mere fraction of what would normally be assessed.
Background: Normally, if someone transfers a remainder interest in property to a trust with a beneficiary, the remainder interest's value is set at zero for gift-tax purposes. In other words, the donor is treated as having made a current taxable gift equal to the fair-market value of the property, even though the beneficiary isn't receiving the property until sometime in the future.
Fortunately, a special tax law exception applies to personal residence trusts. It says that the value of the taxable gift is reduced by the retained interest in your home. So the donor is entitled to a gift-tax discount when the home is transferred to the trust. Also, the beneficiary eventually receives the property without any additional tax cost. And no estate tax or gift tax applies to any future appreciation in the home. If the term of your retained interest is lengthened, the donor is able to establish a lower value for the remainder interest.
Caution: If the donor dies before the end of the term, the full value of the home will be included in his or her taxable estate. It doesn't matter what your original intentions were. So the best strategy is to set a retained interest that will provide a valuable gift-tax discount, but is still reasonable, given life expectancy and personal circumstances.
During the time the trust is in existence, the donor continues to pay the mortgage interest, property taxes, insurance, etc. Because the donor is still the legal owner of the trust, he or she can generally claim the same deductions that would be allowed for an outright owner.
Although a personal residence trust cannot be used to hold other assets, the donor can provide the trust with enough cash to pay the necessary expenses for a period of six months.
Can this arrangement be used for a vacation home? The answer is "yes." The tax rules apply to the owner's main home and one other home such as a cottage or beach house used for vacationing.
