Case of the Week

Case:

Rhea Jones, 75, lives in a beautiful coastal town in northern California. Rhea's home occupies three magnificent acres of bluff property overlooking the crashing waves of the Pacific. With a home that sits just steps away from the dramatic cliffs, Rhea frequently jokes to her friends about her "living on the edge" lifestyle.

Rhea's husband of 50 years, John, built the custom home 10 years ago. It was truly the realization of their lifelong dream. Unfortunately, John passed away unexpectedly five years ago. Now, Rhea lives alone in the large home. Nevertheless, she is looking forward to spending her remaining days in this lovely home. Not surprisingly, she frequently plays host to her children, grandchildren and friends.

Rhea is an active philanthropist. In fact, she spends three days a week volunteering with local charities. While very wealthy and philanthropic, Rhea makes only modest yearly gifts. However, she intends to make a substantial bequest upon her death. Specifically, Rhea plans on distributing her entire estate to her children and grandchildren, except for her cliff-side home. Rhea's will provides that the home, which is worth $3 million, passes to John and Rhea's favorite charity upon her death.

However, at a recent estate planning presentation, Rhea discovered the benefits of a gift of a remainder interest in a personal residence. In particular, she liked the potential significant tax savings and the home's avoidance of the probate process. Also, because the gift is irrevocable, the local charity would recognize and honor Rhea for her generous gift at the annual fundraising gala. Of course, Rhea would retain the right to live in her home for the rest of her life, which is an absolute requirement to any potential gift arrangement.

Question:

Rhea is very excited about this gift arrangement, but she has many questions. Before she commits to the gift plan, she wants to address several issues. In particular, Rhea learns that now is an excellent time for gifts of remainder interests in a home. Why is this so?

Solution:

A gift of a remainder interest in a home produces a charitable income tax deduction equal to the actuarial value of the remainder interest. When computing the remainder interest value, an applicable federal rate (AFR) must be used. With each gift, a donor may select from three available AFRs - the current month AFR, the previous month AFR or the second previous month AFR. For gifts of remainder interests in a personal residence, the lowest available AFR produces the largest charitable income tax deduction. This means timing and planning may provide a tax opportunity for Rhea.

At the time of Rhea's proposed gift, the AFR is at a relatively low level. Thus, it is a great time to complete a gift of a remainder interest in a home. For instance, if the AFR were 4.0%, Rhea's charitable deduction would be approximately $1.9 million. However, if Rhea gifts her home when the AFR is 2.2%, her deduction increases to over $2.2 million.

Although retired, Rhea still receives significant income each year from her IRA, John's pension plan and her income producing investments. Moreover, she plans on selling several million-dollar investment properties during the next several years, because she no longer wants the hassle and management associated with them. This will undoubtedly result in substantial capital gains tax. As a result, she will have six and seven figure taxable income to report over the next several years.

With a large charitable income tax deduction, Rhea will greatly and effectively reduce her future income tax liability over the next six years, using part of the deduction in the current year and carrying forward the remaining deduction amount for up to five additional years. Consequently, Rhea continues the gift planning process with unbridled enthusiasm.