The Deferred Gift of a Personal Residence

Winter 2010Articles The Gazebo

We were recently consulted by an couple interested in making a gift to Bucks. They were not in a financial position to make an immediate cash gift, and wanted to know of other alternatives to benefit the Bucks. They were also interested in advice on how to reduce their federal income, gift and estate taxes, as well as Pennsylvania Inheritance taxes.

After discussing some of the usual methods available to reduce these taxes, such as outright gifts of cash, securities, and other property, we presented to the Donors a unique plan of utilizing their personal residence to make a gift to Bucks. This planning technique, known as a deferred gift of a personal residence, provides an immediate federal income tax charitable deduction, as well as federal gift and estate tax and Pennsylvania Inheritance tax savings for their estates.

To take advantage of this tax saving opportunity, the Donors agree to transfer ownership of their residence to Bucks, to take effect after both of them have passed away, while retaining use of the residence for so long as either of them lives. For this purpose, any personal residence, including a principal residence, a condominium, a co-op, or a vacation home, is treated as a personal residence. The transfer must be by a Deed, which would contain the following provisions:

1. Donors would decide upon the length of time their occupancy is to continue - either for their joint lifetimes or a shorter period of years (hereinafter referred to as the "Term Interest").

2. During the Term Interest, the Donors will retain the use and continue to occupy the residence.

3. Upon the expiration of the Term Interest, the residence would belong to Bucks, as a charitable gift from the Donors.

4. If the Term Interest is for a stated number of years and the Donors outlive that term, they could extend their occupancy by entering into a lease with Bucks for an additional period at a fair rental.

The Donors and Bucks would enter into a joint ownership agreement to cover certain situations that may arise during the Term Interest, such as sale or lease of the residence, condemnation, capital improvements and distribution of insurance proceeds due to damage or destruction of the residence. Subject to the provisions of such agreement, the Donors will continue to use and enjoy the residence during the Term Interest. There are some additional features to be noted:

1. The household furnishings will not be included in the transfer and will remain the Donors’ individual property for their exclusive use.

2. The fact that the residence is subject to a mortgage does not affect its status as a personal residence. It will, however, affect the amount of the tax deductions.

3. While they occupy the residence, the Donors would pay the maintenance expenses, taxes, insurance and can advance the cost of any improvements to the residence.

In the year the residence is transferred, the Donors will be entitled to a federal income tax charitable deduction, subject to the various percentage limitations, equal to the present value of the residence that Bucks will receive at the end of the Term Interest. The IRS has issued regulations and actuarial tables that describe how to calculate the amount of this deduction. For example, assume the Donors are ages 65 and 60 and they retained life interests. The fair market value of the personal residence is $500,000, with the land valued at $100,000 and the building at $400,000 (with a $250,000 salvage value for depreciation purposes). If the property is deeded in a month when the IRS interest rate is 2% (the rate for October, 2010), the value of the federal income tax charitable deduction for the Donors would be $257,929.

Generally, the older the Donors are, the higher their federal income tax deduction will be.
In the example above, if the Donors’ ages were instead 75 and 70 and they retained life interests, the value of the federal income tax charitable deduction would be $321,200. Further, if the Term Interest retained is for a period less than the Donors’ joint lives, the amount of their federal income tax charitable deduction will be increased. For example, if the Donors retained a Term Interest of 10 years, the federal income tax charitable deduction would be $382,830.

There will be no federal income or gift taxes payable when the residence is transferred, even
if it has appreciated in value over its original cost. A gift tax return must be filed for the year of the transfer. However, because of the charitable deduction, there will be no reduction of the tax exemption of $1,000,000 for federal gift taxes allowed to each of the Donors. In some states and counties, there may be a real estate transfer tax imposed when the Deed is recorded, based on the value of the charity’s interest. Philadelphia and the surrounding counties and the Commonwealth of Pennsylvania impose a realty transfer tax on the transfer based on the value of the charity’s interest.

If the residence is subject to a mortgage, the Donors would continue to make regular payments and would be entitled to a federal income tax deduction for the interest portion of such payments. In addition, since the mortgage reduces the value of their charitable deduction, they should be entitled to a further federal income tax charitable deduction for the principal portion of each payment. Similarly, if the Donors make capital improvements to the residence, they should be entitled to an additional federal income tax charitable deduction to the extent that the charity’s interest is enhanced.

There will be no federal estate or Pennsylvania Inheritance tax payable by their estates upon the death of either Donor on account of the residence, because the interest of the surviving spouse will qualify for the marital deduction and the remainder to Bucks upon the death of the survivor will qualify for the charitable deduction. The effect of the plan is to remove the residence from the Donors’ estates for both federal and state death tax purposes.