Unlike many people, who give little or no thought to estate planning, Lorraine Sodaro has been paying attention to such affairs. And with good reason.
When her husband of 40 years died suddenly of a massive heart attack in 1981, she was faced with an unexpectedly large federal tax on his estate. "It was terrible," she said in an interview in her desert home. "I never quite got over that."
With that bitter lesson in mind, she's been seeking ways to help her two children avoid a similar experience.
The 72-year-old widow moved to the desert from Santa Monica five years ago.
Last year she bought an $800,000 home in an Indian Wells community. She occupies her time with volunteer work, frequent visits with children and grandchildren and with travel.
She's also applied herself to planning her estate with a commitment that is rare among her friends, she said. "People don't want to talk about death, so they avoid making plans," Sodaro said. "They are comfortable talking about birth, but what's wrong with talking about death?"
Sodaro, with the help of an estate planning attorney (who experts agree are essential for a large or complicated estate), has employed a variety of techniques to guard her assets from the tax collector. A family limited partnership (topic of the third part of this series), plus trusts and annual tax-free gifts to her children are part of her arrangements.
But the centerpiece of her estate planning is a qualified personal residence trust (QPRT), and she has put her Indian Wells home into it. The QPRT allows her to pass the home to her children during her lifetime, avoiding estate taxes on the property when she dies.
The QPRT is an irrevocable trust that allows you to give your home to anyone you choose, but to continue to live in it during the term of the trust. Sodaro chose to give her home to her children, but it could have been another family member or a friend. And, if you own a vacation home, you can create a separate QPRT for it as well.
Here's how a QPRT works:
Using an attorney, you set up a trust and put your home into it for a specific period of time--say 5, 10 or 15 years. Sodaro, for example, chose a seven-year term.
During that term, you live in the home, continue to pay all the bills (mortgage, taxes, insurance, utilities, etc.), and even sell it if you like--a condition of the trust. (If you sell the home and buy another house, the new home goes into the trust.)
In fact, except for submitting a gift tax return the year you create the trust, it's almost as if nothing has changed. However, under the QPRT, something quite important has occurred:
By creating the trust you are considered by the Internal Revenue Service to be making a gift of the home at its current value--not some future, appreciated value. And you are allowed to reduce that current worth by 1) the value of your right to live in the house and 2) your right to give it away by a will if you die before the QPRT term ends.
To determine the actual dollar amount of these two reductions in value, the IRS publishes statistical tables that put specific values on your right to live in the house and on your right to give it away. The values are based on your age and life expectancy at the time the trust is created. Naturally, your health as well as age are major factors to consider when choosing the term.
And this is where the only significant risk of a QPRT exists: If you die before the term of the trust ends, all bets are off--the home once again becomes part of your taxable estate.
However, should you survive the term, the home is transferred to whomever you're giving it to and your estate is reduced by the value of the home.
Once the home has been transferred to the new owner, you have two choices: remain in the house and pay fair-market rent or move elsewhere.
Some of Sodaro's friends are wary of renting from children. "They don't trust their children. I trust my children completely," she said. "I know they won't put me out once the house is theirs."
But any worry about being evicted can be eliminated, say legal experts. A properly drafted QPRT can give the donor an option to lease the house back when the trust ends and the ownership passes to the recipient.
Estate planners see the currently depressed value of California real estate as a real advantage for those considering a QPRT. The next three years are "choice," said attorney Jon J. Gallo of Century City. That's because any property going into a QPRT is valued at its current, depressed price, sheltering it from any appreciation that might occur during the term.
As for the cost of a QPRT, some $500 worth of consultation time with an estate-planning attorney is probably necessary to determine if the trust is even appropriate for you. If it is, a tailor-made QPRT can range from $1,500 to $2,000.
Your accountant will charge about $150 to file the gift tax return; an attorney, on the other hand, is likely to charge $500.
Experts say it's best to pay off any remaining mortgage before putting the property into the trust. Additional expense is involved if you don't, because annual gift tax returns are required as the mortgage is paid down.
As Sodaro reflected on her estate-planning accomplishments of the past year, she observed, "I am very relieved. I feel I've done everything I possibly can (to minimize estate taxes), and nature can take care of the rest of it."
How the QPRT Works
Here's a hypothetical example of how the qualified personal residence trust works:
You've got a $500,000 home to put into the trust. You're a healthy 65-year-old so you pick a 15-year term. (The longer the term, the smaller the gift to the children because you're living in the house longer, making the gift worth less.)
By consulting the IRS table that refers to your age and the 15-year term you've picked, your attorney tells you that your right to live in it for 15 years is valued at $300,000. The table also values the right to give this house away by a will as worth $100,000. (These are two rights you retain in the trust.) The $100,000 remaining value of the house is considered a gift to your children or a friend.
Since the IRS--at least for the time being--allows a $600,000 lifetime gift-tax exemption, all you need do is file a gift tax return that says you've made a $100,000 gift, which, of course, is well within the $600,000 lifetime exemption.