Estate Planning
Estate Planning For A Florida Homestead

Estate Planning for a Florida Homestead

The Problem

Planning for the transfer of a Florida homestead on death can be surprisingly difficult. Florida law provides that the homestead cannot be devised (i.e., disposed of by will) if the owner is survived by a spouse or a minor child, but instead must pass in equal shares to the children (or their descendants) of the owner, subject to a life estate in the surviving spouse. That is, the children get the homestead, but the surviving spouse, if any, gets the right to live there for so long as he or she is alive. The one exception is that the homestead can be devised to the surviving spouse if there are no minor children.

Very few people want their homestead to actually pass as provided by Florida law. Why, for example, would anyone want to transfer real property to a minor child? And many people want to do something else with their homestead, such as cutting out a wayward child and/or directing a post-death sale of the homestead. In the latter case, the clients may want the proceeds either held in trust or distributed in some fashion other than in equal shares to the last owner’s descendants.

Joint Title

If title is held jointly with rights of survivorship (i.e., a tenancy by the entireties), the property passes to the surviving spouse without reference to the above-described Florida law. While that is often satisfactory, in many instances such passage merely delays the homestead problem until the death of the survivor.

Revocable “Living” Trusts

Many estate planners advise clients to transfer title of homestead to a revocable living trust; the idea being that the homestead would then pass on death as provided in the trust, rather than as provided by Florida law. Unfortunately, that advice is simply wrong. Florida homestead law continues to apply in such circumstances as if the transfer to the trust had not occurred—a prescription for disaster. 

Irrevocable Trusts

The obvious solution is to make a gift of an interest in the homestead to an irrevocable trust. The trick is to design the trust so that there is minimal real-world impact during the lifetime of the owner and to get the fair-market-value basis on the owner's death. This is most easily accomplished by having the owner act as trustee and by only transferring a remainder interest to the irrevocable trust (i.e., the owner retains the right to possession for some time period, such as his or her lifetime).

Gift Taxation

Unless such transfer of a remainder interest is to an irrevocable trust designed to make the gift “incomplete” (see next paragraph), the transfer is a taxable gift, requiring the filing of a federal gift tax return. Compounding the problem, unless certain technical requirements are met, the gift is equal to the full fair market value of the home even though only a remainder interest was transferred. This is true even if the remainder interest were sold to the irrevocable trust for its fair market value.

To avoid gift taxation, the owner could make a gift of a remainder interest while retaining a limited power to alter the rights of the trust beneficiaries. This would render the gift “incomplete” for gift tax purposes. (Even though incomplete for federal gift tax purposes, the transaction would nevertheless be a valid gift for purposes of Florida law.)

Estate Taxation

If the owner dies while still owning the right to possess the homestead or a power to alter the rights of the trust beneficiaries, the homestead is included in his or her taxable estate as if the transfer to the irrevocable trust had not occurred. (To avoid double taxation, any prior taxable gift of an interest in the homestead would offset the estate tax value.) The problem, of course, is that inclusion of the full date-of-death value of the homestead would generally be inconsistent with the goal of avoiding estate and gift taxation.

QPRTs

The Basic Structure

The best way to achieve estate tax reduction with respect to a homestead while simultaneously achieving the dual goals of retaining the right to possess and avoiding the Florida law regarding who takes on death of the owner is for the owner (the “grantor”) to declare that he or she is holding title of his or her principal residence as trustee of a qualified personal residence trust (QPRT). The QPRT is an irrevocable trust which provides that the grantor’s only right in the homestead consists of the right to possess the homestead for a pre-established number of years (the “term” of the trust). Each person may establish a QPRT for his or her primary residence and one other personal-use residence (e.g., a beach condo).

Ideally, on expiration of the term the homestead would pass to the grantor as trustee of a second irrevocable trust, presumably for the benefit of his or her family. The grantor would then continue to have the right to possess the homestead by renting it from such second trust.  The rent paid has the effect of a gift without being considered a gift for gift tax purposes.

If the homestead is sold or insurance proceeds are received for damages, any funds not used to buy a replacement or to repair the damages are used to pay an annuity of, say, 8% of the principal to the grantor for the balance of the QPRT term.

If the homestead is owned by a husband and wife, a preliminary step might be to divide the homestead into equal tenancies in common without rights of survivorship. Each spouse would then transfer his or her half interest to himself or herself as trustee of his or her own QPRT. Such a structure has the side benefit of achieving valuation discounts (for partial interests) for gift tax purposes.

Transfer Taxation

If the grantor survives the QPRT term, the homestead is not included in his or her taxable estate. However, there is a taxable gift (requiring a gift tax return) on the transfer to the QPRT, measured by the value of the homestead less the value of the grantor’s retained (rent-free) right of possession.

For example, a retained 15-year term might mean the gift is only half of the current value of the homestead. If the homestead doubles in value and the grantor dies just after the 15-year term, the taxable gift would have been only one-fourth of the value of the property passing to the beneficiaries, thus achieving substantial estate tax savings.

Since a longer term increases the value of the grantor’s retained right to possess, a longer term yields a smaller taxable gift. But there is a trade-off: if the grantor dies during the term, the date-of-death value of the homestead will be included in the estate. Even so, consequences are generally no worse than if no QPRT had been established, and the QPRT governs disposition of the homestead instead of Florida law.

The Emotional Problem

While many taxpayers have emotional reservations about renting their own home, they often engage in regular gifting programs taking maximum advantage of the annual exclusions. One way to alleviate the hurdle is to view rent as nontaxable gifts to children beyond what the gifting program achieves. An alternative is to “take half a bite,” establishing the QPRT only with the second home.

Income Taxation

Properly designed, both the QPRT and the second (“family”) trust will be treated as grantor trusts for federal income tax purposes—i.e., disregarded entities. All assets, liabilities, income, and expenses of both trusts are treated as the grantor’s. Thus, the grantor continues to deduct mortgage interest and real estate taxes and continues to qualify for the exclusion of gain on sale of the homestead.

Grantor trust status also means that the rent is not reportable as taxable income (it’s a payment to oneself). On the same logic, after the QPRT term expires, the grantor can purchase the homestead back from the second trust for its then-market value without triggering income taxation—potentially preserving a fair-market-value-on-date-of-death basis at death.

The Short-Term QPRT

Suppose the QPRT term is only two years. The gift element would be larger than with a long-term QPRT, but the risk of death during the term would be much smaller. The big benefit is that rent would commence much sooner, dissipating the grantor’s taxable estate and functioning as an enhancement of the gifting program. Taxable income generated by investing the rent would be reported by the grantor, further reducing the taxable estate. The “gift” to the family trust is leveraged because neither the trust nor its beneficiaries are subject to income taxation on that rent.

An Example

With reasonable assumptions, significant estate tax benefits could result from a short-term QPRT. Suppose a $300,000 homestead is owned by a husband and wife. They transfer it to themselves as equal tenants in common (no survivorship), and each declares that he or she is holding his or her half interest as trustee of a 2-year QPRT. After two years, each half passes to an irrevocable family trust (with one or both spouses as trustee).

The taxable gifts on formation of the QPRTs would be, say, $200,000, using part of the respective exemption equivalents. After two years the rent would be, say, $36,000 per year plus CPI. Over the following 15 years the total rent would be, say, $700,000 and the earnings thereon, say, $350,000—reported by the grantors on their 1040. If the survivor dies at the end of the 15-year period and the homestead is worth $600,000, the children receive $1,050,000 in the trust plus the $600,000 homestead, with only $200,000 of gifts reported—while the grantors’ taxable estates have been reduced by income taxes paid on the earnings.

Ad Valorem Exemption

A downside of the QPRT is that the homestead may not qualify for the homestead ad valorem exemption. This can be mitigated if the grantor retains an interest exceeding $25,000 (e.g., retain 10% if the assessed value is $250,000), though the complexity often isn’t worth it. Overall tax and non-tax benefits of transferring 100% to a short-term QPRT and leasing from a family trust may outweigh the added ad valorem burden.

Exemption from Creditors

Since both the QPRT and the second (“family”) trust are typically designed to avoid the grantor’s creditors, loss of homestead status for the exemption from creditors generally does not render the homestead available to the grantor’s creditors. The only possible exception would be where creditors existed (or were contemplated) at the time of the transfer to the QPRT; but even that is suspect, because the homestead was exempt from creditors to begin with.