Ask the Expert
Jennifer Davis, trusts and estates practice group
Greensfelder, Hemker & Gale
How can people in real estate best capitalize on the current gift tax exemption climate?
For 2011 and 2012, the gift tax exemption was increased to $5 million from $1 million. People may optimize this unprecedented opportunity for giving because asset valuations and interest rates are low. It allows people to make gifts when they have the greatest potential for increasing in value.
For example, a $1 million home now worth $300,000 as a result of the economic downturn can be passed on to children using just 6 percent of the $5 million exemption, instead of 20 percent of the exemption if it had retained its $1 million value. Because the home will probably increase in value, the children get the appreciation estate tax free. It uses less of the gift tax exemption to remove the property from the estate for estate tax purposes.
Historically low interest rates have made grantor retained annuity trusts, called GRATs, more appealing. A GRAT is a transfer of property to a trust with a right to receive a percentage of the property back each year. The Internal Revenue Service uses a government-defined interest rate — known as the applicable federal rate or AFR — to value the property. If the rate of the total return of the GRAT's assets is higher than the AFR in the month the GRAT is created, the excess return passes estate-tax-free to beneficiaries of the trust.
Likewise, an installment sale to a grantor trust exchanges a promissory note for another asset, usually a business, securities or real estate. If the total return of the assets is more than the interest rate on the note (the AFR), the excess return can pass estate-tax-free to family members. In effect, the person making the gift is lending assets to a trust for family members. The lower the AFR, the less that must be paid back to the person making the gift as the lender, and the more that passes estate- or gift-tax-free to children and grandchildren.