Estate Tax Planning: QTIP Trusts

Do you care what happens to your assets after you die?

I suspect that it is very important to you.  You may want to make sure that your spouse is provided for, or that your children will be the ones that inherit your property.  What you probably do not want is to pay a penny more in estate taxes than you have to.

Everyone's situation is different, and an estate planning tool that may work for someone else may not work for you.  Therefore, it is very important that you work closely with an estate planning attorney and a CPA to come up with a plan that will best fit your needs.

A few months ago we discussed one estate tax planning tool, the portability election.  Today, I am going to go over the basics of the Qualified Terminal Interest Property (QTIP) trust.

What are the goals of a QTIP Trust?

While there are potential estate tax minimization benefits to this type of trust, the primary benefits to making the QTIP election are in maintaining control of the assets after death.  Specifically, it allows you to provide for your spouse during the remainder of his/her life, but ensure that ultimately the assets will go to the beneficiaries that you choose.

Because of this, QTIP trusts are very popular in situations where one spouse has children from a different relationship or where remarriage after the death of the first spouse is likely.

How does the QTIP Trust work?

Under the terms of the QTIP trust, all of the income earned by the assets placed in the trust goes to the surviving spouse.  In addition, most QTIP Trusts allow for the trustee to give the surviving spouse some of the trust principal (the assets) in addition to the income if it serves a specific purpose.  For example, if there is a medical emergency and the surviving spouse does not have enough money to pay for treatment, the trustee may be allowed by the trust to take assets out of the trust to pay the medical bill.

Upon the death of the surviving spouse, all of the trust assets will go to the beneficiaries named by the first to die (the spouse who originally funded the QTIP trust).

What are the estate tax benefits?

The assets placed into a QTIP trust qualify for the unlimited marital estate tax deduction.  This means that they will not be subject to the estate tax at the time of the first spouse to die's death.  However, these assets will be included in the surviving spouse's estate and subject to the estate tax at the surviving spouse's death.  If the portability election is made at the time of the first spouse to die's death, the surviving spouse will be able to use his/her prior deceased spouse's unused exclusion amount in addition to his/her own exclusion.

If you think that the QTIP trust is an estate planning tool that may work for you, I would be happy to refer you to a great estate planning attorney.

I would also be happy to answer estate tax planning questions that you have. Please just send me an e-mail.

As always, please leave your feedback in the comments section below.

Forced to do a Short Sale of Your Home?

In a letter to Senator Barbara Boxer, the IRS took the position that when a California homeowner sells the property through a "short sale" the mortgage will be treated as a non-recourse debt.

I know, you are wondering what that means, let alone if it is in English.

Let me try to break it down for you.

Under the Internal Revenue Code, when you owe someone money and that person forgives the debt, you are treated as having received income equal to the amount of forgiven debt.  This is known as "cancellation of indebtedness (COD) income".

Example:  Jill loans John $20.  A week later Jill tells John that he does not have to repay her the $20.  The IRS considers that $20 income to John because he would not have had it unless there was first a loan and then the loan was forgiven.

Why would a lender, like a bank, forgive your debt?  Typically, it is because the lender is convinced that you are unable to repay it.  In a housing situation, it may be because the house is "under water" and the bank has decided that it makes more financial sense to allow the homeowner to do a short sale (in which the bank approves a sale for less than the mortgage on the property, and forgives the debt on the excess mortgage) than risk having the homeowner stop making mortgage payments and be forced into a foreclosure.

For the past few years, Congress and California had an exception to the normal COD income rules.  The exception was that if the cancellation of indebtedness is for a mortgage on a person's principal residence, the COD income would be excluded from the person's taxes.  However, this exception expired in California on December 31, 2012, and it expired for the federal government on December 31, 2013.

The expiration of this exception was alarming to many.  It meant that not only would people be losing their homes, but they would have to pay the IRS and California significant amounts in taxes in order to lose their homes.  Senator Boxer reacted and sent the IRS a letter asking how it intended to treat California short sales.

The IRS responded (IRS Letter) that because under California law a lender cannot attempt to collect the excess mortgage from the seller in a short sale, the short sale effectively converts the mortgage into a non-recourse debt.

What does all this mean to you?

It means that, in California, a taxpayer who participates in a short sale does not have to recognize "cancellation of indebtedness" income.  The debt is forgiven and there are no adverse tax consequences as a result of the short sale.

California has indicated that they will follow the IRS's position on this issue.

Are you considering doing a short sale of your home?  If so, I would be happy to discuss this more with you.  Just send me an e-mail.

Also, I would be happy to refer you to a great realtor that specializes in short sales.

As always, please leave your feedback in the comments section below.

Update: The IRS has reversed its position and now does require taxpayers to recognize the cancellation of indebtedness income unless they fall into another exclusion.

Selling Your Home?

Are you looking to sell your home?  Then you may be able to take advantage of a major tax benefit!

You may be entitled to exclude $250,000 of gain from the sale of your personal residence.  If you are married, you may be entitled to exclude $500,000 of gain!

In order to exclude this gain, you must meet 3 tests.

1. Ownership Test.   You must have owned the home as a principal residence for at least 2 of the 5 years prior to the sale.  If married, either or both spouses can meet this test.
2. Use Test.  You must have used the home as a principal residence for at least 2 of the 5 years prior to the sale.  If married, both spouses must meet this test.
3. Frequency Test.  The exclusion applies to only one sale every 2 years.  If married, this test is not met if either spouse has claimed this exclusion within the past 2 years.

If both spouses do not meet the use and frequency test, then a portion of the exclusion may still be claimed.  In this case, instead of being able to claim the full $500,000 exclusion, the couple would only be able to claim the $250,000 if one spouse meets all 3 tests.

Even if you do not meet these tests, you may be able to claim a reduced exclusion!  A reduced exclusion is available if you sold your principal residence because of:

• A change in your place of employment;
• Health reasons; or
• Unforeseen circumstances.

There is a safe harbor rule defining what qualifies under each of these three exceptions.

Lets look at an example.  In April 2012, John and Jane Smith purchased a small, 2 bedroom house for $500,000.  In September 2013, Jane gave birth to twins and they decided that they needed a larger home to accommodate their larger family.  In October 2013, with the help of a great realtor, the Smiths sold the same house for $800,000.

The Smiths have $300,000 of gain on the sale of their home.  They are afraid they will have to pay taxes on the full $300,000, but they talk to a CPA and learn that they do not have to.  Although they did not meet the 2 year ownership and use tests, they qualified for a reduced exclusion because the birth of multiple children from the same pregnancy is considered an "unforeseen circumstance."  Because they owned and lived in the house for 18 months, they are able to take a reduced exclusion of $375,000 which is enough to eliminate their entire taxable gain.  They do not have to pay any tax on the sale and can use the extra $300,000 to buy a bigger house!

If you are considering selling your home and would like to learn more about this exclusion, please do not hesitate to send me an e-mail.  I would also be happy to talk to you about how having a home office or converting the house into a rental property will affect this exclusion.

Also, I would be happy to refer you to a great San Diego realtor.

As always, please leave your feedback in the comments section below.

Organizing Your Taxes

For many people, the most daunting part of having their annual income tax returns prepared is simply getting themselves organized.

 

 

At Reid, Sahm, Isaacs & Schmelzlen, LLP, we attempt to make this process easier on our clients by providing them with a tax organizer in early January.  The tax organizer simply reminds the client of the various tax forms that they will receive, and also provides a space for clients to provide other necessary information, such as how many business miles they drove during the year or what their total medical expenses were.

 

Just in case your CPA has not provided you with a tax organizer and you are feeling overwhelmed, here is some advice on how to organize your documents.  I would suggest creating 3 separate "piles".

1. Tax Documents

   Over the next month, you will be mailed a number of tax documents.  These include your W-2, and a number of documents that start with either the numbers "1098" or "1099".  It may also be a K-1 if you are a partner in a partnership or a shareholder in an S-Corporation.   To keep it simple, I would simply group these by type (all the W-2s together, etc.)  Your CPA will gather the necessary information from these forms directly, so unless there is something missing there is no need for you to do anything further with them.
   
   
2. Financial Statements
   

   If you own a business (as a sole proprietor) or rental property, you most likely are already keeping track of your income and expenses.  You may receive some tax documents, like a 1098 for the mortgage interest, but the most important numbers are located within your "books".  Just check these statements to make sure that they are accurate, and then provide them to your CPA.

    
3. Other Records
   

   In order to claim your deductions and credits, it is up to you to find the records proving that you are entitled to the deduction.  This means keeping track of your property tax statements, medical expenses, charitable contributions (you need to keep the acknowledgement letters you receive), and the amounts you spent as part of your job that you were not reimbursed for.  Don't forget to check your credit card statements because a lot of your deductions may be listed there for you.  This is the most challenging part of getting your documents ready for your CPA, but try to think of it as the most rewarding part because the receipts you find potentially mean the less taxes you will have to pay.

If you have any questions or need help preparing your 2013 income taxes, please do not hesitate to send me an e-mail.

 

As always, I appreciate all the feedback you leave in the comments section below.