Defining Qualified Dividends

Corporations pay dividends to their investors. These dividends can be paid as cash, stock, or some other property. Dividends are the investors’ share of corporate profit over a certain time period. The IRS taxes dividends as income. The most common type of payouts to investors is ordinary dividend. The IRS considers these dividends to be ordinary income and taxes them at the taxpayer’s normal tax rate. Dividends are always considered to be ordinary, unless a corporation specifies otherwise.

For a dividend to be considered qualified, it must be issued by a U.S. corporation or a qualified foreign corporation. It cannot fall into the unqualified category, and it must meet the required holding period.

Qualified dividends that would ordinarily fall into a 25% tax rate are taxed at 15% and dividends that would fall under the 25% tax rate are taxed at zero percent.

You must own the stock providing the dividend for more than 60 days of a prescribed 121-day period. The holding period basically persuades long-term investment in order to guarantee that the stock falls into the qualified category where tax savings are realized.

Although calculating the dividends yourself can become complex, the IRS requires the corporation issuing the dividends to report those that are qualified as a special entry in box 1b of your 1099-DIV and ordinary dividends in box 1a.

Ordinary dividends add to your adjusted gross income. The IRS provides a work sheet for you to use to calculate the tax rate of qualified dividends after taking into consideration elements like income and filing status. You deduct qualified dividends from your income and use the worksheet to determine their tax rate. You then calculate the tax owed on your adjusted gross income after the dividends were deducted. You next add the tax rate you determined on your worksheet to the tax you owe on your income, and you have determined your total tax.

Upon completion of your income tax return, you will discover that calculating the special reduced rate of qualified dividends has lowered your tax liability.

The bottom line is that all the calculations save you money. So, it is well worth doing the math.

Wealth Building

Winding Up a Qualified Personal Resident Trust

The Qualified Personal Residence Trust, or QPRT, became popular a couple of decades ago as a way to save gift and estate taxes. Now that many of the earlier trusts are expiring, families have to proceed carefully to protect their tax benefits.

Let’s take, for example, the case of a man called Brian. In August 1997, Brian met with his estate planning attorney. Because he was a widower with a net worth of $3 million at that time, and only a $600,000 federal unified gift and estate tax exemption, the attorney convinced him to transfer his $1 million home into an irrevocable trust (a QPRT) with a 15-year term. During the next 15 years, Brian continued to live in his home rent-free, and assuming he was still living at the end of the term, ownership of the house would then transfer to his children.

Since Brian gifted a future interest in the property to his children, the Internal Revenue Service granted him a valuation discount for the value of the interest he retained in the home. If he had died before the end of the QPRT term, the home and any other assets in the trust would have reverted back to his estate, essentially canceling the trust without realizing any tax savings. The IRS also granted Brian an additional valuation discount for the possibility of this reversion. These valuation discounts were calculated based on Brian’s age, the IRS-approved Section 7520 applicable federal rate of interest at the time he created the trust, and the length of the QPRT term.

Due to these valuation discounts, the value of Brian’s gift was only about $460,000 for federal gift tax purposes, even though his home was worth $1 million. Because the value of the gift was below Brian’s $600,000 lifetime exemption, he owed no gift tax upon creating and funding the QPRT. Thus, the QPRT provided the potential for significant gift and estate tax savings, not only on the value of the house at the trust’s creation but also on any future home appreciation thereafter.

Fast-forward almost 15 years – 14 years and eight months, to be exact. Within four months, the QPRT term will end. Brian is currently in good health; his home has a current fair market value of $2 million; and his net worth excluding the value of the home is now $4.65 million. With a current federal unified gift and estate tax exemption of $5.12 million, if Brian passed away after August, he would have shielded over $1.5 million from federal estate taxes. Establishing the QPRT was a great decision.

However, he wants to continue living in the house after the trust term ends, so he visits his estate planning attorney to consider his options.

The attorney informs Brian that in August, at the end of the QPRT term, his children will replace him as trustees. At that time, his children will most likely dissolve the trust and transfer title of the property into their individual names or into an entity, such as a limited liability company, that they own equally. If Brian continues to live in the house at that time, he will need to start paying his children fair market rent. Otherwise the IRS will contend that there was an understanding between Brian and his children that, at the time they took ownership of the home, he would retain use of the property rent-free for the rest of his life. Such an arrangement would result in the residence being included in Brian’s gross estate at his death, and all that great estate planning would go to waste.

Further, the attorney mentions the possibility that Congress will allow the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (“TRA 2010”), which President Obama signed into law in 2010, to sunset on January 1, 2013, causing the estate tax exemption and top estate tax rate to return to $1 million and 55 percent respectively, resulting in a much higher estate tax bill if the house is included in Brian’s estate.

Because of his net worth and the possible sunset of TRA 2010, Brian decides that he has no qualms about paying his children fair market rent. Not only will he avoid undoing his estate plan, he will also benefit from transferring additional wealth to his heirs, in the form of rent, without incurring gift tax. However, depending on the amount of deductions related to the property (such as real estate taxes, insurance, repairs, maintenance, and depreciation), the rental income may generate additional income tax liability for Brian’s children.

To ensure that Brian receives the benefits of the QPRT, he will need to take the following steps.

  • If he has not already done so, Brian should inform his children that the QPRT exists, and that they will become the owners of his home when it ends.
  • Before the trust term ends, Brian will need to enter a lease agreementwith his children. (This will demonstrate to the IRS that there was no implied agreement between Brian and his children that he would continue to reside in the home rent-free at the end of the trust term, and further, that Brian’s children have sole right to possession of the home.)
  • After the deeds have been signed and recorded with the county, Brian will want to contact his insurance company to cancel his homeowner’s insurance and obtain a renter’s policy.

Brian should also make sure his children know to take some steps of their own to ensure the transfer goes smoothly. They should:

  • Either obtain a letter stating the fair market rent from a local real estate broker or pay for a fair market rent appraisal. (The payment of fair market rent will help avoid an IRS challenge that Brian continued control and enjoyment of the home, so as not to bring the home back into his estate.)
  • Hire a real estate attorney to draft the formal lease agreement. The agreement should be for at least one year and provide for automatic renewals unless canceled by either party. Further, the rental amount should be revisited at the end of each lease term to ensure that Brian continues to pay fair market rent.
  • Have the real estate attorney draft the necessary legal documents to allow the children to accept trusteeship after the QPRT term ends, and to transfer title of the property from the trust to either their individual names or to the entity they establish to hold the property.
  • If the children plan to hold the property in an LLC, to limit their liability against a lawsuit from someone that gets injured on the property, they should also have the attorney draft the LLC formation documents.
  • Obtain an appraisal to determine the home’s fair market value, since they will be converting the property to a rental home. They will need the market value in order to claim a depreciation deduction against rental income.
  • Obtain new title insurance on the property once they become the owners.
  • Once they own the house, they should also obtain homeowner’s insurance and inform the insurer that the home will be used as a rental property. This may increase the cost of insuring the property. However, the children should also mention that they will be renting it to their parent, the previous owner, and not some unrelated third-party, as this may result in either minimal or no increase in premium.

A well-managed QPRT can provide substantial estate tax savings. However, if you do not take the necessary steps to wind it up properly, Uncle Sam may still get a stake in the house.

Wealth Building

What Is a Qualified Personal Residence Trust (QPRT)?

A QPRT is a form of irrevocable living trust designed to reduce the amount of gift and estate tax generally incurred when transferring an asset to a beneficiary. According to law the QPRT is a suitable legal technique to shield an individual’s assets for their beneficiaries and protects those assets from creditors and judgments. An irrevocable trust cannot be changed in any way while the trust is in effect. This helps to guarantee that a judge cannot merely order a person to surrender protected assets to creditors or change the circumstances of the trust which would allow others to obtain the asset.

Once the residence has been transferred to the trust via a properly prepared and executed deed, the transferee(s) retain(s) the right to live in that home for a set number of years. While the owner is residing in the house, no rent would be paid. The owner is responsible for all housing expenses like repairs, real estate taxes, and maintenance fees which is covered by Revenue Procedure 2003-42 [2003-23 IRB 993 section 4 Art. II (B) (2)]. If the owner is alive after that predetermined number of years the trust automatically transfers ownership of the home to the owners’ beneficiaries without having to pay estate tax. The beneficiaries can rent the home out to the original owner of the house. The most appealing part of this plan is that paying rent after the QPRT has ended the owner transfers additional assets to their beneficiaries without having to pay any gift or estate tax. Having received the rent money from the parents does not preclude them from giving the money back to the parents. If the house is sold, the proceeds from the sale can be used to purchase another house or other items for the parents as the beneficiaries’ desire.

The QPRT’s main advantage is the tax savings it provides to the property owner and the beneficiaries of the trust. When the residence is conveyed to the QPRT it counts as a gift but a typical IRS gift tax is not assessed. Instead the IRS computes a modified gift tax based on published tables and the total of time the home stays in the QPRT, which is applied to the value of the home. Once the time period of the trust ends, which is agreed upon when creating the QPRT, and the owner is still alive then the residence is passed on to the beneficiaries free of any gift or estate tax.

If the residence has appreciated in value since its original appraisal, the gift tax is based on that value of the home – based on the IRS calculations – and not on the increased value of the home. If the home’s value does not increase or stays the same then the beneficiaries would not have to pay any gift tax on the home.

Another benefit of the QPRT is the tax benefits can be enhanced if a husband and wife own the home jointly. According to Treasury Regulations section 25.2702-5(c)(2)(iv) a husband and wife can both transfer half their ownership in the home into two separate QPRTs. Each separate QPRT allows the husband and wife owners to live in the residence for a set number of years based on the conditions of each QPRT. In the case of one homeowner dies before the QPRT ends, the half that was in the trust would be put into the estate and be subject to estate and gift taxes. So what happens if you want to sell the house that is under a QPRT and buy a new home? The trustee of the QPRT would simply sell the old home and buy a new one in the name of the QPRT. If the value of the new home is greater than the old home, then the trustee would be required to pay out from separate funds and retain ownership for that portion of the house.

Wealth Building

What is a Qualified Domestic Trust (QDOT)?

The term “QDOT” is an acronym for “Qualified Domestic Trust.” Some people prefer to use the acronym “QDT,” but we’ll refer to this type of trust as a QDOT. Qualified Domestic Trusts were created under the Technical & Miscellaneous Revenue Act of 1988 (TAMRA), effective for decedents dying after November 10, 1988. Prior to TAMRA, the unlimited marital deduction was not allowed when property passed to a surviving spouse who was not a United States citizen. The creation of QDOTs was designed to provide a mechanism whereby property could pass to a non-U.S. citizen spouse and still qualify for the unlimited marital deduction. That’s what QDOTs are all about. Now, let’s take a closer look at the requirements for a QDOT and some of the reasons for these requirements. Historically, the transfer of property from one spouse to another has not been subject to either a gift tax or an estate tax. The reason is simply because most married couples depend upon their combined assets for their financial security. If a gift or estate tax is levied every time one spouse transfers property to the other, their combined assets would be seriously depleted in short order and their financial security may well be placed in jeopardy.

And, that is particularly true when one of the spouses dies. Remember, the gift and estate tax rates can be as high as 45% of the value of the property transferred. Think of a married couple as one economic unit. As long as property remains within that economic unit, the federal government keeps its hands off the property. Married couples can transfer property from one spouse to the other as often as they’d like, either during lifetime or upon death. It is only when property is transferred outside the economic unit (i.e., to someone other than the surviving spouse) that the federal government puts its hand out. That’s not to say that the federal government exempts inter-spousal transfers from the gift and estate tax. On the contrary, it subjects these transfers to the gift and estate tax, but then gives a corresponding deduction equal to the full value of the property transferred. This deduction is called a marital deduction because it only applies to transfers from one spouse to another. Furthermore, it is called an “unlimited marital deduction” because there is no limit on the amount of property that qualifies for the marital deduction. The use of an unlimited marital deduction, rather than an outright exemption, effectively defers the tax until the death of the surviving spouse.

Keep in mind that the federal government is not as benevolent as you might think. Although it is willing to defer the estate tax until the death of the surviving spouse, it is not willing to forgive the tax entirely. In fact, the federal government won’t even allow the tax to be deferred upon the first spouse’s death unless there is a reasonable certainty that the property will be subject to tax upon the surviving spouse’s death. How does the federal government determine whether there is a reasonable certainty that the property will be subject to tax upon the surviving spouse’s death? It does so by imposing a three-prong test at the time of the first spouse’s death. If all three-prongs are satisfied, then property passing to the surviving spouse qualifies for the unlimited marital deduction. The three-prongs of this test are: (1) that the property is being transferred to a bona fide spouse of the decedent; (2) that the spouse of the decedent is a U.S. citizen; and, (3) that the spouse of the decedent is not given a terminable interest in the property. If all three-prongs of the test are met, then the unlimited marital deduction applies and the estate tax is deferred until the death of the surviving spouse. It is important to note that there is no requirement that the surviving spouse actually keep the property until he or she dies. In fact, it’s entirely feasible that some or all of the property will be consumed by the surviving spouse during his or her lifetime.

That is the whole idea behind the so-called “economic unit” theory that drives the unlimited marital deduction in the first place. Now, let’s take a closer look at this three-prong test to qualify for the unlimited marital deduction. The first prong requires that the property be transferred to a bona fide spouse. Historically, only valid marital relationships between a man and a woman were considered worthy of protection against a potentially devastating gift or estate tax. Today, those historic beliefs have come under attack and at least six states have now authorized same-sex marriages. Presumably, same-sex marriages will be tested soon against the “bona fide” spouse requirement for the unlimited marital deduction. That, however, is the subject of another day. The second prong requires the surviving spouse to receive the entire rights to the property transferred. In other words, the property given to the surviving spouse must not be terminable. Generally speaking, a terminable interest is akin to having certain strings attached to the property, which makes it doubtful that the property will be taxed in the surviving spouse’s estate. For example, if the surviving spouse is given a life use of the property and cannot designate who will receive the property upon his or her death, then that property is deemed to be terminable interest property.

As such, it would not be subject to tax in the surviving spouse’s estate and, therefore, it does not qualify for the unlimited marital deduction. There is, however, an exception for terminable interest property placed in a “Qualified Terminable Interest Property Trust,” or “QTIP Trust,” Again, however, that is the subject of another day. The third prong of the test requires that the surviving spouse be a U.S. citizen. Again, the federal government wants to be reasonably certain that the property will be taxed in the surviving spouse’s estate. If the surviving spouse isn’t a U.S. citizen at the time of the first spouse’s death, then there is a good possibility that the estate tax will not be collected when the surviving subsequently dies, simply because the federal government doesn’t have the power or authority to tax property owned by a non-resident, non-U.S. citizen, unless the property is physically located in the United States. So, if a U.S. citizen dies and leaves all of his property to his wife who is a not a U.S. citizen, then there is nothing to stop the surviving wife from returning to her native country and taking all the property with her. In that case, none of the property would be subject to tax by the federal government when she subsequently dies. To prevent this from happening, the unlimited marital deduction is denied for any property given to a surviving spouse who isn’t a U.S. citizen. While the citizenship requirement is easy to justify, it’s application can be very harsh – especially for those who have resided in the United States for years and years without obtaining citizenship, but with no intention of ever returning to their native country. For this reason, the federal government created an alternative way to qualify for the unlimited marital deduction when property is given to a non-U.S. citizen spouse. The alternative is to transfer the property to a Qualified Domestic Trust (QDOT) instead of giving it directly to the surviving spouse. In order to qualify as a Qualified Domestic Trust (QDOT), the federal government imposes the following requirements:

  • At least one trustee must be a U.S. citizen or a U.S. bank. If the QDOT holds more than $2 million dollars in cash or property, the trustee must be a U.S. bank.
  • The executor of the decedent’s estate must make an irrevocable QDOT election to qualify for the marital deduction on the federal estate tax return within 9 months from the date of death.
  • If the QDOT has assets equal to or less than $2,000,000, then no more than 35% of the value can be in real property outside of the United States or else: (1) the U.S. trustee must be a bank, (2) the individual U.S. trustee must furnish a bond for 65% of the value of the QDOT assets at the transferor’s demise, or (3) the individual U.S. trustee must furnish an irrevocable letter of credit to the U.S. government for 65% of the value.
  • If the QDOT has assets exceeding $2,000,000 either: (1) the U.S. trustee must be a bank, (2) the individual U.S. trustee must furnish a bond for 65% of the value of the QDOT assets at the transferor’s demise, or (3) the individual U.S. trustee must furnish an irrevocable letter of credit to the U.S. government for 65% of the value.

In addition to the above requirements, any distributions of principal to the surviving spouse will be subject to estate taxes, and the trustee is required to withhold funds equal to the tax. However, exceptions are made for principal distributions for the health, education or support of the surviving spouse or a child or other person whom the spouse is legally obligated to support, as long as substantial financial need exists. Any property that the deceased spouse transfers to the surviving spouse outside of the QDOT (i.e., directly as a result of jointly-owned property, or through a will or some other means) may be transferred to the QDOT without being subject to the estate tax if the property is transferred prior to the estate tax return’s due date. If the deceased spouse’s will does not provide for a QDOT, the executor or the surviving spouse may elect to establish a QDOT and transfer the assets to the trust before the date on which the tax return is due. It should be noted, however, that the best way to insure the availability of the marital deduction is to have the non-U.S. citizen spouse establish citizenship beforehand. If that is not possible, then the U.S. citizen spouse should take the necessary steps to insure that a QDOT is established in his or her will and/or living trust so that the QDOT is established automatically upon his or her death.


BIG TAX BENEFITS? Qualified Opportunity Zones

I received another call last week about someone wanting to invest in an Opportunity Zone (OZ). I asked “Why?” and they said, “To save on taxes and make more money.”

OK, I understand and that is a good answer, but what is the plan? How will you save money on taxes? How much will you save? There seems to be a lot of hype around OZs, and for good reason. They could be great, but it has to be the right situation and planned correctly. Because of the hype, and misunderstanding, I wanted to share my understanding on what OZs are and how you, as an investor, can benefit from them.

Legislation passed in 2017 allowing the US Treasury Department to created OZs. In 2018, the information on the incentives were released. Because this is so new, it is highly misunderstood. The idea is to spur economic growth in real estate and jobs by giving tax benefits to investors for investing in businesses or real estate located in certain parts of town. The zones are determined by the state and approved by the federal government. My understanding of this is the only tax benefit is some deferrals and forgiveness of long-term capital gains tax, and there are some hoops to jump through.

First, an individual cannot invest in a piece of property in an OZ. For an investment to qualify for the tax incentives it must invest in the OZ through an opportunity fund (OF). An OF is an entity that is taxed as a corporation or partnership, like an LLC, that invests at least 90% of its equity into OZs. According to the IRS, for an entity to qualify as an OF is simply self certifies by filing a form with the IRS.

The tax benefits can be big. Investors can defer paying taxes on gains if they invest gains into an OF. This works very similar to a 1031 exchange, but it does not need to be a like kind exchange, meaning you could liquidate other investments, like stocks, and defer gains on those. The deferring of taxes gets even better with OZs because the amount you pay on the gain reduces over time. If you invest in an OZ and hold the investment for 5 years you will reduce your gain by 10%, which in turn reduces your taxes. For example, if you have a $50,000 gain from the sale of stocks that you roll into an OZ, after 5 years the report-able gain that you will pay tax on reduces by $5,000 making the taxable gain $45,000. If you hold the assets for 7 years, the gain is reduced another 5%. Making the taxable gain $42,500. In 2026 you will need to pay tax on the differed capital gain whether you sell the asset or not. The big benefit however is when you hold the property for 10 years. After 10 years, you will pay no capital gain on any appreciation on the asset from the day you purchased it. So, if your investment increases in value $100,000 over 10 years and you sell it, you pay $0 in taxes.

Being forced to use OFs to invest in OZs is interesting. From what I can tell, it is done this way to attract larger investments for the largest impact, but I did not find anything saying you cannot set up your own OF to invest in a single property in an OZ. These benefits are big, but the way I see it, it only makes a good deal better. I would not specifically invest in an OZ just for the tax break.

Myths of Opportunity Zones: Here are the two most common myths about opportunity zones that I hear:

I can roll capital gains into OZs, hold the property for 10 years and never pay tax on the gain.

It is true that you will never pay tax on the capital gains from the original investment after 10 years, but you will need to pay taxes on the gains you rolled over in tax year 2026. The gains that you roll into an OZ is simply differed and will reduce over time, but it will never be eliminated.

I can buy a rental in an OZ for big tax savings.

There are two reasons this won’t work. One of the hurdles to OZ investing is that you need to invest through a OF. Once you identify an investment you will need to set up a separate LLC, partnership or corporation to invest in that property and then notify the IRS that your entity qualifies as an OF.

A much more confusing hurdle is substantial improvement. According to IRC Sec. 1400Z-2(d)(2)(D)(I), qualified OZ property held by a qualified OF must satisfy one of the following requirements:

The original use of qualified opportunity zone property commences with the qualified opportunity zone fund, or

The qualified opportunity zone fund substantially improves the property.

The way I understand this is that if you purchase a property you will need to either build new (new original use) or make major improvements. There was recently clarity on the definition to “substantially improves.”

To qualify for substantially improves, you will need to make improvements that doubles your basis (make improvements that equal the amount paid for the asset) in any 30-month period while the asset is owned. The basis does subtract the land value, so the improvements needs to equal the value of the improvements only. For example, let’s say you buy a rental for $100,000. According to the county assessor the value of the land is $20,000. In order to qualify for the tax incentive, you will need invest another $80,000 into the property within a 30-month period at some point in the next 10 years before you can sell the asset.

So, what’s the strategy?

The obvious strategy is to buy land in OZs and build to hold. Other strategies for real estate investors could be to buy and scrape to build town-homes or condos. In those cases, you will want to hold on to a few of the units as rentals for at least 10 years. Another option that I can see some creative investors taking advantage of is accessor building units (ADUs). These are small out buildings or additions used as additional units or apartments. These are becoming more popular with the boom in Airbnb in many areas, you don’t need to be zoned for multifamily to build them. Because of the regulation on short term rentals, you may need to rent these out as long-term rentals, but the number could still work. I can see if you buy a single-family house in need of repair, by the time you rehab the house and build an ADU you could qualify for the tax incentive.

To see a map of the OZs in your area you can visit the US Treasuries site here.