Leave The Homestead To Your Kids, Tax Free

Death doesn't always have to mean taxes, particularly when it comes to real estate. Parents can bequeath the house to their kids in a trust that removes it from the Internal Revenue Service's gun sights.

By law, only $600,000 of an estate is exempt from tax. But many houses are worth at least that much. Throw in other assets, and you have a juicy estate subject to federal taxes ranging from 37% to 55%, depending on its size. Most states also impose their own inheritance levies. Giving the place to the kids now won't help: The house will be subject to gift taxes on every dollar of value above $10,000.

TIME LIMIT. A shrewd strategy is to put the house into a grantor-retained income trust. This makes it exempt from estate taxes and allows the parents to continue living there rent-free. Tax-free transfer of residential property is one of the few survivors of last year's tax-code tightening, which yanked securities and rental property from trust eligibility.

This trust must have a time limit, and many people choose 10 years. Shorter terms reduce the amount of tax savings under IRS calculations. As long as the parents outlive the decade-long term, ownership is fully transferred to the children. If both grantors die before that time, the trust is nullified and so are the savings. If one dies, the savings are halved. "But they are better off trying a trust than not trying. There is no downside," says Samuel Friedman, a tax lawyer at Hall, Dickler, Lawler, Kent & Friedman in New York.

Let's say a couple, both 63, has a $3 million estate that includes a house worth $500,000 in today's market. They decide to set up a trust for 10 years, after which ownership of the house will pass to their daughter. At the end of the 10 years, she can keep them on as tenants. When they die, the house--whose value may have climbed to $600,000--will not be part of the taxable estate.

ALL PAID UP. Quirks of tax math make a brain tickler out of calculating the daughter's savings, but they are substantial. After the trust's 10-year term, tax tables adjust the $600,000 home down to $450,000 in something similar to depreciation. Assuming a 50% estate-tax rate, that means pulling the house out of the estate yields $225,000 in tax savings.

Two caveats: It's best that the house have no mortgage. Otherwise, the IRS will treat part of the house transfer to the daughter as forgiveness of debt and charge her parents for it. Also, after the 10 years expire, the daughter must charge her parents rent at prevailing rates. Considering the money kept from the IRS, that's not such a hardship.

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