Disclaiming inheritance from a Trust as tax avoidance for property transfer

[apnar]

Here is a simplified hypothetical that describes the question:

• Person A and B are tenants in common in a property that is valued at $1,000,000 and has a basis of $200,000.
• Their mother dies leaving them $2,000,000 in a trust to be distributed equally.
• Person A disclaims $500,000 of his inheritance from the trust.
• Person B signs a quitclaim deed transferring all ownership in the shared property to A.

The result is Person A fully owns the property and received $500,000 from the trust; Person B received $1,500,000 from the trust.

Presuming all totals are under various federal and state gifting/inheritance/estate tax limits is this a completely tax-free situation?

My initial thought is this approach is ok and tax free. Disclaiming a portion of the inheritance is not viewed as a gift, payment, or any other consideration from A to B since A did not have control of how the disclaimed funds would be distributed (even though he was aware of what the outcome would be). Then the quitclaim transfer would be viewed as a gift since there was no consideration in exchange for it.

 

[adjusterjack]

The federal gift tax and estate tax exclusions are 11 or 12 million dollars or so. Federal tax would not be an issue either way.

However, you did not reveal the state, as you were asked when you posted, and that's important because some states have inheritance taxes and some don't.

 

[LdiJ]

Here is a simplified hypothetical that describes the question:

• Person A and B are tenants in common in a property that is valued at $1,000,000 and has a basis of $200,000.
• Their mother dies leaving them $2,000,000 in a trust to be distributed equally.
• Person A disclaims $500,000 of his inheritance from the trust.
• Person B signs a quitclaim deed transferring all ownership in the shared property to A.

The result is Person A fully owns the property and received $500,000 from the trust; Person B received $1,500,000 from the trust.

Presuming all totals are under various federal and state gifting/inheritance/estate tax limits is this a completely tax-free situation?

My initial thought is this approach is ok and tax free. Disclaiming a portion of the inheritance is not viewed as a gift, payment, or any other consideration from A to B since A did not have control of how the disclaimed funds would be distributed (even though he was aware of what the outcome would be). Then the quitclaim transfer would be viewed as a gift since there was no consideration in exchange for it.

I follow your logic, but I think that you need a consult with a local attorney. A trust is not necessarily an inheritance per se, so the rules for disclaiming might not be what you think in your unnamed state.

A gift tax return would need to be filed for the gift of 1/2 of the property, but as longer as someone is below the life time exclusion for gifting (whatever it would be at the time) there would not be any tax on the gift.

 

[Taxing Matters]

Presuming all totals are under various federal and state gifting/inheritance/estate tax limits is this a completely tax-free situation?

Assuming this is done by agreement between A & B then it is not tax free. The inheritance would not be subject to federal estate tax so long as her taxable estate did not exceed the amount of unified credit she had left when she died.

However, since the disclaimer is being done in exchange for the quit claim the IRS will not treat it as a gift of the property interest from B to A. It would instead be treated as what it is economically: a sale of B's half interest in the property to A in exchange for A's disclaimer of the $500,000 which ends up going to B. This is an application of the doctrine of substance over form. While in form you've set it up to look like a tax free event (other than B using up $500,000 of his unified credit) when you look at the real substance of the transaction, what is really going on her is a sale of the property interest from B to A. Thus, B would recognize capital gain income on this deal.

 

[LdiJ]

Assuming this is done by agreement between A & B then it is not tax free. The inheritance would not be subject to federal estate tax so long as her taxable estate did not exceed the amount of unified credit she had left when she died.

However, since the disclaimer is being done in exchange for the quit claim the IRS will not treat it as a gift of the property interest from B to A. It would instead be treated as what it is economically: a sale of B's half interest in the property to A in exchange for A's disclaimer of the $500,000 which ends up going to B. This is an application of the doctrine of substance over form. While in form you've set it up to look like a tax free event (other than B using up $500,000 of his unified credit) when you look at the real substance of the transaction, what is really going on her is a sale of the property interest from B to A. Thus, B would recognize capital gain income on this deal.

I was looking at it from a different perspective and I think that I got it wrong. I was looking at this more from the standpoint of they are basically inheriting everything (house too). Since they clearly owned the house prior to mom dying, that obviously isn't the case. However, if they owned the home due to a TOD dead from mom would that change your opinion any?

 

[Taxing Matters]

I was looking at it from a different perspective and I think that I got it wrong. I was looking at this more from the standpoint of they are basically inheriting everything (house too). Since they clearly owned the house prior to mom dying, that obviously isn't the case. However, if they owned the home due to a TOD [deed] from mom would that change your opinion any?

If A & B had no interest in the home prior to Mom's death and get the property by inheritance or transfer on death deed then of course the property gets a basis equal to fair market value (FMV) on the date of Mom's death, i.e. the basis becomes $1 million. If they then do the disclaimer and quit claim deed the transaction is still viewed the same way: in substance this is a sale of B's interest to A for $500,000. But now B has a basis of $500,000 in that interest so he recognizes no gain or loss in the deal.